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Behavioral Finance

Why Investors Fail: An Intro to Behavioral Finance

The biggest threat to your investing strategy, it turns out, is you. Learn how these innate behavioral biases can sabotage returns.

Articles by MP Dunleavey

By MP Dunleavey
  |  Published: September 19, 2013

Human beings aren't hardwired to be good investors.

It’s smart to recognize the reflexes may "feel right", but actually skew your financial choices.

Here's the bottom line: Doing less, not more—and using smart systems that help you—is the best way to set yourself up for investing success. Learn more about Betterment

 It can’t be said enough: Human beings are usually their own worst enemies when it comes to making smart financial choices.

In fact, the impact of behavioral biases on investing is so well-documented that you can only gain by understanding how these innate flaws interfere with your goals—and you can set up your financial life to get around them.

Here, the top three to be aware of:

Bias #1: Inertia

The biggest threat to financial success is inaction, pure but not-so-simple. Why do you (why does anyone!) resist taking steps that will help you save or grow your money?

Consider the historically low participation in 401k plans. Companies that offered these plans didn’t know what to make of the lackluster interest on the part of employees—until researchers identified the problem: sheer inertia. So, rather than asking people to actively sign up for a retirement account, scientists argued, employees should be automatically enrolled in the company plan.

Once enrolled, people would be less likely to leave the plan and stop saving, because, again, they’d succumb to inaction—but now that inertia would work in their favor. And it did. So-called auto-enrollment programs increased 401k participation from 63% to 95%, according to a TIAA-CREF study, echoing similar findings at other companies.

To thwart inertia and keep your money growing, take advantage of automation in any way you can.

  • Saving automatically, whether into a savings account or 401k, increases how much you save.
  • Putting your bills on autopilot means fewer late fees.
  • Using an automated investment plan will help you fund a portfolio.

Without automation, the inclination to procrastinate, hesitate, or hem and haw will undermine your plans.

Bias #2: Familiarity

You like what you know, because it makes you feel comfortable. But the bias toward what’s familiar is not the best investing strategy because it prevents you from diversifying your portfolio.

One of the most famous examples is what happened to Enron employees who kept the majority of their portfolios in company stock. Don’t invest where you work—diversify.

 You can build diversification into your portfolio by investing in index and exchange-traded funds (ETFs): low-cost, passive vehicles that track many different market sectors.

Rather than putting yourself in a position of having to vet dozens of different companies, ETFs and index funds give you broad exposure to thousands of companies and industries. You don’t have to worry about which international or bio-tech companies are worth putting a toe into; index funds and ETFs that track those markets let you break out of the familiar to reap gains in new waters (without exposing yourself to one company going bankrupt).

Bias #3: The News

How and why do many investors end up making lousy choices? Often, they react to recent events and big headlines, a.k.a. recency or availability bias. Your decisions get skewed by what grabs your attention.

In a well-known study, Werner de Bondt and Richard Thaler (who’s also a pioneer in the inertia research described above) identified 35 top performing U.S. stocks over a three-year period (the “winners”), and the 35 worst performers (the “losers”). They then tracked the performance of the winning stocks versus the losers against a representative market index for three years.

Who wants to be a loser?

Guess which group came out ahead? Right: the “losers.” Investors tended to react to recent events, which drove down the price of certain stocks. When those events faded, the stocks regained value in investors’ eyes.

The only cure for the tendency to overreact to recent news is to seek out the horizon; take the long view. You don’t want to track the trends or respond to the news. In fact, the less you do, the better.

The hidden benefit of being biased

While you can’t change the financial reflexes you’re born with, you can set yourself up for success with a system that’s designed to counteract your own worst instincts—so you gain instead of losing.

Note that the common theme underlying the solutions to these problems is, generally, doing less so that your (biased) behavioral tendencies don’t accidentally throw a wrench into your portfolio.

In a way it’s a validation of why human beings evolved these patterns to begin with. You’re not meant to squander your resources worrying about where and how to invest. A simple, efficient system can do that, so you can get back to hunting and gathering and watching “House of Cards.”

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