Your Portfolio’s Four Worst Enemies
Josiah is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When it comes down to investing, there is undoubtedly an endless list of things to worry about. Taxes, commissions, inflation, and freeloading friends might be enough to make you want to stash your money under a mattress.
But it turns out that the average investor’s worst enemy might just be... himself. Here’s an example: American Funds Growth Fund of America (AGTHX), one of the largest equity mutual funds, currently has about $114 billion under management. For the past 15 years, the fund has returned an average of 7.55% per year. Not bad. The only problem is, the performance for the average investor in that fund was only 5.06%, a difference of over 2.49% each year for 15 years! This difference is calculated by the Morningstar® Investor Return™, which accounts for investor behavior by measuring inflows and outflows from the fund. Bond funds are not immune from this either. Famed bond investor Bill Gross’ flagship PIMCO Total Return (PTTRX) fund returned 7.33% a year for the past 15 years, but the Morningstar® Investor Return™ was only 5.84%.
So why does this happen? Cognitive and emotional biases.
One of my favorite companies is Starbucks (NASDAQ: SBUX). Back in 2008, I visited the local store almost every day. So when the stock priced had bounced off from it’s single digits lows, I decided to take a position at around $15. It went on to double in less than two years, and I proudly closed my position for a two-bagger. Well, the stock kept climbing to where it sits today at around $48 a share. I think I’m finally ready to admit why I sold. Here are four of the deadliest investor behaviors:
1. Loss Aversion
Loss aversion occurs when the fear of losing money leads investors to make irrational decisions. This may lead to holding on to losers for too long (I’ll sell it when I break even) and/or sell winners too soon (Good thing I locked in that gain). Sound familiar?
To avoid exhibiting loss aversion, remember to focus on the current and relevant facts. The price you paid isn’t as important as whether the risk/reward is currently favorable. If I had taken a closer look at Starbucks, I would have realized that their growth prospects and business model was still solid.
Anchoring is when you assign a price to a stock, and focus too much on this number. What tends to happen is that the investor neglects to update his analysis of the situation, even if he receives new information. When Netflix (NASDAQ: NFLX) was trading at $40 a share, I decided (arbitrarily) that $37 was a good price to pay. I refused to pay $40 when it was only $37 last week. Needless to say, I missed out on quite a bit.
Dealing with anchoring may be tricky, but a simple trick that might help is to avoid looking at the chart. Force yourself to evaluate the situation as it is, not as it was.
3. Regret Aversion
After watching Netflix run from $40 to $180, I finally decided to pull the trigger. At this point, I had already decided that this DVD rental company was overvalued, but couldn’t bear to keep watching the rising stock price from the sidelines. This is a classic case of regret aversion. Have you ever bought a “hot stock” just because all your friends were making money on it? This fear of getting left behind often leads to bad decisions.
Regret aversion can be difficult to overcome. Investors that exhibit regret aversion are advised to take smaller steps and to ease into their positions.
4. Self Attribution and Overconfidence Bias
Self attribution bias occurs when an individual takes credit for positive outcomes (regardless of whether they deserve it or not), and blame others for negative outcomes. Known as an ego defense mechanism, this happens quite naturally in most individual investors. Self attribution bias often leads to overconfidence bias, which causes investors to believe they have more control of a situation than they actually do. This eventually causes the individual to underestimate risk, and overestimate their expected return.
If you suffer from self attribution or overconfidence bias, keep records of your trades, including the strategy and reason behind the trade. Afterwards, go back and review your analysis for both profitable and unprofitable trades. Were you correct, or was it just luck?
In a recent study done by Morningstar® with 178 people, 71% of the participants exhibited anchoring, 62% displayed regret aversion, and 61% were subject to loss aversion. While a sample size of 178 may not be totally comprehensive, the study suggests that these biases affect us more than we think.
jchoy has no positions in the stocks mentioned above. The Motley Fool owns shares of Netflix and Starbucks. Motley Fool newsletter services recommend Netflix and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.