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The Biggest Risk to Your Investments?

Look in the Mirror

Behavioral biases—and the investing mistakes triggered by them—can derail the market gains of even high-net-worth investors. Consider these strategies to help overcome them.

It’s a story almost as old as the stock market itself. Stocks go up, and investors crowd in. When the market drops, as it inevitably does, they stampede to the exits. The types of emotions that might be indispensable to us in other facets of life often lead to negative outcomes as investors: fear of missing out on the next big thing, panic at the thought of losing money, an eager focus on the recent past at the expense of a long-term view. The list goes on.

You may think you’re above such foibles, but are you sure? While wealthy investors tend toward different biases than average-income investors, they’re not immune to the blind spots that lead to investing mistakes.

Certainly, research shows that, overall, investors shortchange themselves in the financial markets. The average equity mutual fund investor earned just 5.5 percent in 2014, compared with the overall equity market’s 13.7 percent return, largely due to mistiming the market, according to the 2015 Quantitative Analysis of Investor Behavior, an annual report published by DALBAR, a financial services consulting firm.

While studies with different methodologies find investors’ underperformance to be less glaring, they still find a gap of about 1 to 2 percent between the market’s return and the typical investor’s return annually.

That shortfall adds up over time. One study found that the total return of UK equity funds was 6.5 percent, but the average investor earned 5.3 percent — a difference that compounded into a loss for the average investor of almost 20 percent over 10 years, according to research conducted by Cass Business School for financial firm Barclays.

Each investor is different, of course, with individual attributes that potentially prompt a unique response to the market’s gyrations. That said, generalizations can be made. For example, investors with assets of more than $30 million might be less likely than middle-income or even wealthy investors to sell in a panic.

Generally, ultra-high-net-worth investors know they’ll be passing a substantial sum on to their heirs, says Richard Peterson, a psychiatrist and chief executive of research at consulting firm MarketPsych LLC. “They tend to really look long term. They’re thinking about generations,” he says. 

Meanwhile, a self-made millionaire who feels confident about his ability to handle his own finances may feel a desire to exert control during a market in free fall — that could mean withdrawing money at precisely the wrong time. “An engineer, an entrepreneur: they’re used to having control over their financial situations,” Peterson says. “That can lead to trouble. Markets aren’t controlled like engineering systems are controlled.”

High-net-worth investors may realize their weaknesses. Forty-one percent of high-net-worth investors said they wish they could “take a more disciplined approach” to their finances, according to a 2011 survey of 2,000 investors worldwide by Barclays.

That awareness doesn’t necessarily lead to better outcomes. In times of market volatility, “people tend to want to act,” says Mark Paccione, director of investment research at CAPTRUST. “They want to feel like they’re in control of things that they’re not in control of.”

In 2012, a few years into the bull market that started in 2009, some clients clamored for more equities. “Hey, why don’t I have more stocks? I’m more aggressive than you guys have me invested,” he remembers clients saying.

A few years earlier, during the financial crisis, many of these same clients had reacted in panic when the stock market went into free fall. That tendency among investors to forget the past and extrapolate the near term into the future — that is, assume that when an investment lately has been gaining, or tanking, that trend will continue — is called recency bias.

For one client who was particularly fervent on equities, Paccione and his team dug up email messages the client had sent during the financial crisis — messages in which the client made it clear he couldn’t stomach the risk. “He thought the U.S. was going to melt down,” Paccione says.

Just four years later, the client was pushing to hike his allocation to equities beyond the balanced portfolio his advisors thought prudent. He and other clients were convinced they were missing out — a feeling often driven by the human tendency toward a herd mentality: If everyone else is doing it, it must be right. That’s perhaps a useful instinct at times. In investing? Not so much.

Keep Egos in Check

Overconfidence is another hindrance to high-net-worth investors’ investing abilities, says Meir Statman, a finance professor at Santa Clara University’s Leavey School of Business.

He points to the difference between an average investor and, say, a multimillionaire who rose to wealth by building a restaurant chain. “The person who owns the restaurants understands competition,” Statman says. But because she’s been successful, she thinks she’ll be successful in any business, including investing, even though the competition includes computer algorithms and professional traders.

Average-income investors, meanwhile, are likelier to commit framing errors, Statman says. “They don’t ask themselves, ‘If I am selling my stocks because I’m sure they’re going to go down, who is the idiot who is buying them?’ They frame it as playing against a practice wall, without realizing that it might be Djokovic on the other side of the net,” he says, referring to the top-ranked tennis pro Novak Djokovic. They fail to see the whole picture. They sell when they should be buying.

“Some people don’t understand they’re playing against Djokovic. Others understand they’re playing against Djokovic, but they think they can beat him anyway,” Statman says. “It’s overconfidence.”

And overconfidence can lead wealthy investors astray in other ways, Statman says. “They are likely to be swayed by an advisor who says, ‘Surely you’re not average. You don’t want to be like those mediocre index-fund investors. You can do better, and I’ll show you how.’” The appeal of that message can sway wealthy investors into high-cost, complex investments that take away from wealth rather than adding to it, Statman says.

Social status can drive behavior too. “If you’re in a circle of friends who talk to you about their successes — of course, they never tell you about their failures — you’re very likely to be swayed by it,” Statman says. To be a successful investor, “It’s very important to keep egos in check.”

That’s easier said than done. The fact that investors are human beings, with all the foibles of our species, means that the work of financial advisors has as much to do with dealing with clients’ emotional drivers than choosing the best investments.

“Taking into account the psychology and personality of a client is just as important, if not more important, as the actual asset allocation,” Paccione says. “If you don’t take into account the client’s personality, whatever plan you put in place is probably going to get blown up at some point.”

Take a 25-year-old client who is conservative, he says: “It doesn’t matter if you think he should be mostly in stocks. If you can’t construct a portfolio where he can stomach the volatility, he’s going to sell those stocks the first time there’s a serious correction, which will be the worst possible time to do it.”

Mental Accounting

Here’s the good news: There are useful strategies to protect investors from their own biases. One of these is the bucket approach. Divide money into investment buckets, each with its own time horizon or goal, such as immediate income or long-term retirement savings.

This approach — also known as mental accounting — does have a negative connotation. Mental accounting also refers to people’s tendency to perceive pools of money differently, depending on their source, such as when those who receive a tax refund consider it found money and spend it, rather than save it as they save other earned income.

But mental accounting, in the sense of using investment buckets, can have the benefit of putting a brake on biases. An investor, for example, may be more willing to accept volatility when he can see the losses are concentrated in his long-term savings.

Paccione says his team often uses three buckets: a capital preservation bucket for immediate spending needs, invested in certificates of deposit, cash, and short-term bonds; an income portfolio of bonds and other yield producers for those clients who are drawing income; and a third bucket for long-term needs, invested for growth in equities and higher-volatility investments.

“When you do have a market sell-off, you have the income account that has not gone down significantly, and while the growth portfolio may be down, you can point to the account that has held up relatively well,” Paccione says. “It gives mental comfort to a client.”

A related strategy is having a sliver of portfolio allocated for high-risk bets. “That strategy really is more for the business executive or the entrepreneurial client — the client who’s used to having some concentrated risk,” says Nick DeCenso, a manager of wealth strategy at CAPTRUST in Raleigh, North Carolina.

Let’s Talk

In some ways, the best strategy financial advisors have is their ability to engage and converse. “Many investors think that the real contribution of advisors is in beating the market. That is really the least of their abilities,” Statman says. Instead, he says, the best advisors manage investor emotions and work to help clients achieve their big-picture goals.

Setting expectations for each piece of an investor’s portfolio is crucial, as is reframing current events within a historical context. For example, in 2009, the government’s response to the economic crisis seemed to signal, to some clients, the beginning of a financial Armageddon. “There was this fear that the Fed was printing money, that the dollar was going in the tank, and that inflation was going to be out of control,” Paccione says.

His solution? “You try to explore how it would actually take place,” he says. For example, “If hyperinflation happens, we’ll definitely see a general rise in prices; there would be time before a Hershey’s bar goes from a buck to $10.” Plus, he tells clients the firm actively monitors for inflation, and he points to the client’s investments that tend to perform well during inflation, such as commodities.

This type of reframing to put current events in context is not unlike one of a series of mental exercises recommended by Peterson of MarketPsych. In times of extreme volatility, he suggests investors ask themselves: “How many times have such things happened in history?”

The answer is “more than once,” and the market survived every time. “Looking at the sweeping history of the markets helps us to stop focusing on the day-to-day moves,” Peterson says. “A longer-term perspective diminishes stress.”

Focus Your Mind

A related tactic — Peterson calls these exercises “perspective shifting” — is to expand one’s focus beyond the markets. “Consider what really matters in your life,” Peterson says. “Does recent stock market performance or money in the bank instill meaning in your life?” Generally, our sources of meaning are found in family, friends, faith, career, and lifelong goals.

“In the grand scheme of your whole life, today’s performance in the stock market is just a tiny iota of all the meaningful things in your life,” he says.

Another strategy: reduce media consumption. “Paying attention to any short-term noise only makes investors’ decisions more impulsive and results poorer,” Peterson says.

Don’t forget that advisors have biases too. That’s one reason advisory firms adopt investment policies that dictate specific actions, such as a percentage range that acts as a signal to rebalance appreciated assets. Similarly, individual investors should devise a plan for their investments and stick to it.

Even advisors find that tough. Says DeCenso: “When a particular asset class hits the skids and it’s down 30 percent, it’s going to feel weird buying it, but it’s a proven plan.” 

About the Author

Andrea Coombes is an award-winning writer with more than 14  years of experience writing personal finance and busines stories for a variety of publications. Her work has appeared in The Wall Street Journal, the Miami Herald, Sacramento Bee, San Francisco Chronicle, San Francisco Examiner, and on Yahoo! Finance. She served as personal finance editor at MarketWatch.com from 2010 through 2012.

 

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