Know Thyself: Behavioral Biases Can Hurt Investment Performance ...

When our portfolios produce a disappointing performance, we often blame external factors rather than fault our own decisions. But most investors are hardly the dispassionate actors of textbook economics. Instead, we build our investment rationales with hidden behavioral biases that hinder our ability to invest successfully.

Investment Bias No. 1: Extrapolation

One of the greatest pitfalls for investors is to extrapolate past performance into the future. When investors assume that a security will be able to extend its positive performance indefinitely they could be making a costly mistake. That?s why investment firms almost always include the caveat that ?past performance does not guarantee future results? as a standard disclosure in their boilerplate.

Investment Bias No. 2: Anchoring

Anchoring bias is a variation of extrapolation. Based on past performance, investors conclude that a portfolio holding is worth a particular target price, and ignore any new information that undermines their original thesis.

As investors cling to that target price, they subsequently fall prey to confirmation bias, which is the tendency to seek out information that confirms their beliefs. And with the proliferation of investment advice on the Internet, it?s easy to find news and analysis that support virtually any investment outlook.

Investment Bias No. 3: Unaware of Investment Bias

Perhaps the worst investor bias of all is the belief that we can actually be unbiased. Investors prefer to view themselves as rational opportunists who aren?t subject to such innate shortcomings. But every decision investors make is steeped in past experience. Although such precedents are useful analytical tools in other areas of human endeavor, they can lead us astray when it comes to investing.

Solutions for Investment Bias

The first step we can take toward overcoming our biases is to recognize that humans are inherently biased. That awareness can then be used to formulate a plan that reduces the impact of such biases in the future.

Trade Infrequently

The simplest approach is to avoid frequent trading. Rather than constantly checking your portfolio, consider monitoring it on a weekly or monthly basis. That will reduce the temptation to overtrade. Regular trading is costlier in terms of commissions and bid/ask spreads, and numerous studies have shown that investors who trade frequently aren?t more likely to outperform the market than those who only make trades once a quarter. It can also be helpful to set a schedule that limits trading to specific days.

Play Devil?s Advocate

Another approach is to seek out information that contradicts your investment thesis. The point of such research isn?t necessarily to change your mind about an investment, but to provide additional context for both the bullish and bearish case for a stock. By considering less optimistic perspectives, you?ll strengthen your analytical abilities and discover potential problems that could affect your investment?s future performance.

Articulate Your Investment Objectives and Risk Tolerance

Finally, all investors should take the time to draft an investment policy that outlines their long-term goals and sets their criteria for buying and selling shares. Composing such a document won?t turn you into an automaton that?s coolly detached from the market?s fray. But it should help you maintain a steady approach to your portfolio even when the markets occasionally descend into chaos.

Source: http://www.investingdaily.com/14652/know-thyself-behavioral-biases-can-hurt-investment-performance

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