Traditional concepts of finance are built upon the idea of efficient markets. In that world, investors are rational, unbiased, logical, and risk-averse. When investors act in accord with these qualities, a stock's price equals its value, and no trading strategy should beat the market.
But those of us who invested in the stock market in the late 1990s suspect that might not always be the case--and we may have even been guilty of a little "irrational exuberance" ourselves.
We're Consistently Irrational
For decades, psychologists have been studying human decision-making and discovered that we are systematically irrational. We tend to consistently act in an irrational manner in certain situations and when making certain decisions. When this discovery was later applied to investing, the field of behavioral finance was born.
Though this field of study has been around for some time, it gained fresh attention following the technology bubble. Investors and economists looking for an explanation for the bubble latched onto many of the tenets of behavioral finance. Princeton University psychology professor Daniel Kahneman, a pioneer in the field of behavioral finance, won a Nobel Prize for Economics in 2002. His work merging psychology and economics led to the development of a more-nuanced understanding of how stocks perform.
Behavioral finance shows that investors are, in reality, emotional, biased, overconfident, and myopic, with a distorted concept of their needs. And this behavior (when practiced en masse) sometimes creates bubbles (technology, real estate) and seasonal swings (such as the so-called January effect, which predicts that stocks rise during that month).
Some investors have been able to profit from investor misbehavior. All-star investors such as Warren Buffett, George Soros, and Bill Miller have consistently outperformed the market. And hedge funds, in aggregate, produce better returns than index-based mutual funds, which merely track the broad market or parts of the market.
But if you're not an all-star money manager, recognizing and correcting these five most-common behavioral mistakes can help you make and keep more money.
1. Investors are biased toward what they know.
They over-allocate to company stock and under-allocate to international investments. According to human-resources consulting firm Hewitt Associates, company stock is the single largest holding for the average 401(k) investor, accounting for almost a quarter of the average portfolio, while international investments make up only about 7% of the mix. Considering that about 50% of the "investable" stock market is outside the U.S., investors are missing out on potential gains and the benefits of diversification, which can reduce the risk in a portfolio.
2. Emotion trumps rational judgment.
People hate to lose more than they like to win. This fear of regret causes investors to hold on to losers too long and sell winners too early. Investors tend to hold on to losing investments hoping that they will come back, rather than taking advantage of tax breaks. The contrary is true with winning stocks. Fearing a downturn and wanting to lock in profits, investors will sell stocks or funds too early and miss out on future gains.
3. Investors have big heads.
The majority of people (though men are more guilty of this than women) think they are better than average at a variety of tasks, such as driving and investing. But by definition, a majority of people can't be above average. This unrealistic assessment of one's own investing prowess causes investors to overtrade and pay the resulting higher fees and taxes.
4. Myopia causes misallocation.
Investors tend to view each investment and each account--401(k), IRA, college-savings account, etc.--in isolation rather than in aggregate. Trying to make every investment a winner can throw off the overarching asset allocation. It can also lead an investor to chase hot stocks, trade excessively, and sell at the wrong time. If all of an investor's accounts and individual investments are up at the same time, they should be alarmed rather than proud. It's a sign that they may be under-diversified and taking on too much risk.
5. More, more, more.
We Americans spend what we earn. In fact, we spend more. The United States, for the first time since the Great Depression, has a negative savings rate. But it doesn't have to be that way. Professors Richard Thaler of the University of Chicago and Shlomo Benartzi of UCLA developed a behavioral finance program called Save More Tomorrow, or SMarT. Under the SMarT program, workers allow automatic deferral increases to their retirement plans each year at raise time. In a test run at one company, 78% of those who were offered the plan joined, and 80% of those stayed in the program. Even more striking, the average savings rates for people in the SMarT program climbed from 3.5% to 13.6% in fewer than four years. So when workers didn't see the decrease in their paychecks, they didn't miss the money.
Using the Information
Simply recognizing the bad behavior can lead to success. To fight familiarity bias, invest more of your money internationally and hedge against company stock if you can't sell it (e.g., buy mutual funds that don't invest much in your industry). Additionally, tools such as Morningstar.com's Portfolio X-Ray can help identify unintended areas of concentration in your portfolio and avoid overlap among your fund and stock holdings. (X-Ray is available only to Morningstar Premium Members, but non-Members can take a free trial.)
Develop a trading strategy and stick with it to take emotion out of the equation. Or, better yet, take a long-term approach to your investments and don't look at them more than once or twice a year.
Remember that most people have average investing skills, so buy and hold a diversified portfolio of investments and control what you can. You can't control the returns from your investments, but you can affect the amount you pay in fees and taxes.
Don't look at your investments individually, but rather take your portfolio as a whole. Web tools such as Morningstar.com's Portfolio Manager can help you organize and categorize your investments. Or consult a financial planner.
And finally, consistently put money away for retirement. The best thing you can do for your portfolio is give it time to grow.
It Gets Easier
Right now some of you may be thinking that this sounds like a lot of work. But your financial life can actually become much easier. Most people's primary savings vehicle is a 401(k) account. The majority of these plans today offer some form of "outsourced decision making" like managed accounts (where your portfolio is managed by a professional, third-party money manager), funds of funds (e.g., target maturity, lifecycle, lifestyle, or balanced funds), and opt-out programs where you are automatically enrolled and assigned an appropriate portfolio and savings rate. Investors who are their own worst enemy or who are stricken with investing inertia may benefit from these offerings by taking themselves out of the equation.
Roger Ibbotson, Ph.D., is founder of Ibbotson Associates and a professor of finance at the Yale School of Management. Morningstar acquired Ibbotson Associates in March 2006, and Professor Ibbotson now acts in a management advisory role for Morningstar.