Why is it so hard for people to manage their own money?Submitted by S. F. Ehrlich Associates, Inc. on February 16th, 2022
February 15, 2022
During bull markets, it may appear as if anything an investor buys will go higher. For individual investors, up is up, and they may even be more emboldened when hearing of others who have made a lot of money. It’s hard not to want in on the party. (How hard can it be? Even so-and-so is getting rich.) Unfortunately, there’s a lot that can go wrong when discipline is lost.
In recent years, there has been considerable material published by behavioral economists on investor behavior. Using research by behavioral economist Jay Mooreland to explain how biases impact decision-making processes and behavior, Schwab1 recently published an article on the topic. While the biases may be easy to identify, they’re quite hard to overcome. (We took the liberty of adding one or two that we have observed over the years.)
- Recency or representative bias: While short-term results are entirely unpredictable (there’s almost an even chance that the stock market will either go up or down each day), investors may believe they can distinguish patterns. One can assume, wrongly or otherwise, that a market (or stock) that goes down 10 days in a row will go up the 11th day. But that’s gambling, not investing. The patterns that an investor sees may really just be the randomness one observes when flipping a coin or spinning a roulette wheel.
- Outcome bias: It’s easy to look at short-term performance and assume, usually wrongly, that a specific investment was a mistake. Investors may view what happens over the next 60, 90, or 180 days as predictive of how the investment will act over the next five years. Patience is a virtue and, left to their own devices, it’s very difficult for individual investors to let an investment strategy evolve over time as it’s intended to do.
- Anchoring bias: When we hear a number, we tend to anchor, or adopt that number. If you read that the stock market returned 10%, you adopt 10% as ‘your’ number. If you fail to reach that number, you may do something more aggressive in the hope that you will achieve that return. Yes, the S&P 500 may have returned an average of 10% per year over the past 100 years, but that isn’t necessarily the return on a broadly diversified portfolio. Unfortunately, anchoring bias causes investors to chase the anchor number and to forget how far the anchor may drop when things go terribly wrong.
- Availability bias: We tend to make judgments based upon the information that is available to us. Listen to a commentator who predicts the stock market will fall or that coffee beans will soar in price, and you’re likely to do two things: sell out of the stock market and stock up on coffee. If you took the time, however, to research both comments, you might discover the opinion of the commentator is in the minority, and that most every prediction he/she has ever made has been wrong. Radio and TV channels have to fill time, and it’s not necessarily true that the people they hire to occupy hours are the smartest at what they do. Further, when they’re wrong, it’s viewed as yesterday’s news. No one cares, except for those who listened to and acted on incorrect advice.
- Hindsight bias: It’s human nature to assume that if a stock soared last year, it will continue to soar the next year. We all have investments we shoulda, coulda, bought, and that mindset can lead us to (wrongly) assume we can pick the next Apple or Amazon. Perhaps that will occur, or perhaps you’ll pick stocks that never fly high.
And to include some additional biases we think could have been included in Schwab’s article:
- Home or domestic bias: Why bother investing in anything except the U.S. stock market? Or domestic large-cap growth stocks? Or mega-cap stocks? Or only tech stocks? We often invest in things that we know, which is comparable to an employee of a publicly owned company investing all of his/her 401k plan into company stock. But just because company management talks a good game doesn’t mean the stock is the best investment your money can buy. (Think Enron, Lehman, Lucent or even long floundering companies like General Electric). Similarly, just because you read and hear news about U.S. markets doesn’t mean there aren’t other opportunities around the world. There are, and foreign markets are just as equipped to outperform U.S. market performance.
- Emotional bias: It's very difficult for any investor not to be impacted by a roaring or crashing stock market. There can be elation when a portfolio grows and sadness when it sinks. Those swings in emotion can cause an investor to take inappropriate steps at exactly the wrong time, such as going all-in when the market is soaring or cashing out when the opposite occurs. The idea of methodically rebalancing is foreign to many, if not most investors because they’re not familiar with the research demonstrating that slow and steady really does win the race. The last thing investors need during good or bad times is to make decisions based upon their euphoria or sorrow. Either can cloud decision-making, just when clear-headedness is needed the most.
Investing for the long-term is hard. If you add various predispositions and prejudices to the mix, it makes trying to achieve one’s long-term goals that much harder.