4 Ways to Beat Your Investing Biases
Discover how a trusted friend and a diary can make you a better investor.
Every group with a sense of its own identity shares a folklore—a system of common beliefs, rooted in human biases, that governs its behavior and shapes its worldview. The denizens of Wall Street are no exception, and their implicit beliefs and assumptions tend to shape investing behavior. But new research from State Street’s Center for Applied Research suggests that the folklore is flawed and can lead investors to make unhealthy decisions.
Start with the folklore that centers on time, says Suzanne Duncan, the CAR’s global head of research. Investors tend to manage money and evaluate success assuming too short a time frame—often just one year—when a decades-long perspective would make more sense. Plus, we tend to give a lot of weight to past performance, even though it’s a poor indicator of future results, and to future forecasts, despite their abysmal track record.
Some investing folklore causes us to take “false comfort” in easily quantified benchmarks. When center researchers asked investors how they measured success, the researchers expected to hear about achieving long-term goals. Instead, participants talked about beating the market and posting gains with no losses—measures that were either impossible or irrelevant to meeting their personal goals, says Duncan.
The folklore of knowledge relates to a subconscious faith in what we think we know. For example, professional portfolio managers tend to take credit for successful investments and blame the duds on external factors—the market, say, or incompetent company executives. Individual investors are merely overconfident. Nearly two-thirds of those polled by center researchers rated their level of financial sophistication as advanced, but they scored an average of 61%, or barely above failing, on a financial literacy test.
Change Your Behavior
It’s time for a new folklore, says Duncan. The first step is to become aware of the behavioral biases that plague us as investors so that we can identify our weaknesses (you can take the center’s quiz yourself). The next step is to change behavior, and Duncan’s group has a host of recommendations:
1. Incorporate a devil’s advocate into your decision-making process to avoid falling victim to groupthink. Draft a friend, family member or colleague; it needn’t be the same person every time.
2. Keep a diary of your investment decisions so you can track what ultimately led to success or failure.
3. Develop a trading discipline with rules for buying or selling. A checklist for each investment decision will ensure you cover every angle and stick to your process.
4. Tweak your asset allocation to suit your own psychological tendencies (or work with an adviser who will help you do so). Investors who cut and run in the face of losses might need less exposure to volatile investments, for instance, even if it means sacrificing some gains. Duncan envisions future target-date funds that will be shaped as much by behavioral factors as by demographic considerations such as age or number of years to retirement.
Most important, we need to start measuring performance in a personalized way, based not only on how much a portfolio beats the market or its peers, but also on how well it meets our needs, whether for income, downside protection or simply to fund our initial investment goal. The folklore of finance will change only when we start benchmarking performance to the individual investor, and not to the S&P 500.