Emotional Biases That Hurt Investor Returns – Part 2

By Amit Rupani

“Only when you combine sound intellect with emotional discipline do you get rational behavior." – Warren Buffett.

Quick Recap of Part 1: Temperament is very important in investing. Emotional stability and keen understanding of how human behavior works in the market dynamics are critical to long-term investment success. An emotion may be thought of as a mental state that arises spontaneously rather than through conscious effort. Most investors unknowingly suffer from emotional biases pushing them to making sub-optimal investment decisions. In Part 1 of this article (published last month and available online at Saathee.com), I shared emotional biases like Loss-aversion, Overconfidence, and Self-Control bias that all investors generally suffer from and ways to overcome them. Emotional biases are harder to correct as they originate from impulse rather than any conscious calculation. In the case of emotional biases, it may only be possible to recognize the bias and adapt to it rather than correct it. Below I share three additional emotional biases.

Status-quo bias is a bias in which investors do nothing instead of making a change, even if it might be financially optimal to do so. Investors tend to accept the current situation and default to the same decision every time. This includes holding on to current stock and not selling it in spite of the losses it is generating. Change is not easy and it's often easier to avoid the uncertainty of change and stay with the status-quo. Changing the status-quo requires a lot of decision-making, and those with decision fatigue prefer not to give any load to their brains.

The status-quo bias leads to financial inertia. The investors with status-quo bias end up remaining where they were, even when there were enough chances and opportunities for them to upgrade their economic conditions. These investors fail to explore new opportunities. As a result of the status-quo bias, the investors also end up maintaining a portfolio that is far away from its optimal allocation in the present. In the past, the portfolio could have been optimum and ideal. However, in the rapidly changing economic and financial environment, the same portfolio may not remain optimal.

Not only does status-quo cause risk aversion, it may also cause excessive risk-taking, at times. When an investor is holding on to the investments that are not appropriate for their risk and return profile, they are either taking excessive risks or being too conservative. Both the situations lead to less than optimal outcomes.

So when was the last time you reviewed and changed your 401k or IRA mutual fund allocation? Did you work towards moving towards discount broker to save on transaction cost? When was the last you rebalanced your portfolio to realign your portfolio with your risk, return, and goals?

Endowment bias is an emotional bias in which investors value an asset more when they hold rights to it than when they do not. However, psychologists have found that when asked, investors tend to state minimum selling prices for a good that exceed maximum purchase prices that they are willing to pay for the same good. Effectively, ownership “endows" the asset with added value. Endowment bias can affect attitudes toward items owned for long periods of time or can occur immediately when an item is acquired. Endowment bias may apply to inherited or purchased securities.

How does this relate to investing? Investors become unusually attached to holdings within their portfolio. Somehow they are unwilling to sell something they have put a great deal of time and effort into acquiring. What is even more amazing – if they had a chance for a clean slate (completely new portfolio), they may not make those investments today. A quick and simple test to expose this flaw it to take an objective view (easier said than done) of the entire portfolio – position by position. Would we be willing to buy each position today? Our answers may be surprising. Another possibility - have someone else provide an independent eye to your positions. They won't be victim to the endowment effect that potentially colors your view.

Regret-Aversion bias is an emotional bias in which investors tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. Simply put, investors try to avoid the pain of regret associated with bad decisions. This tendency is especially prevalent in investment decision making. Regret bias has two dimension; actions that investors take and actions that investors could have taken. Regret from action taken is called error of commission, and regret from action not taken is called an error of omission. Let's assume you bought a stock for $10. There are two possibilities; either the price will go down or up (ignoring flat pricing). If it goes down you would regret that you purchased too early and could have purchased later at lower price. If it goes up, you would regret that you could have purchased more when it was available at lower price.

Regret aversion related to errors of omission, investor takes action with the fear of missing out on profitable investment opportunities that others are enjoying. Therefore, they invest with the crowd. This not only increases the investor's fear of missing out, it also reduces the intensity of regret that happens if the investment turns negative, as the burden of responsibility is shared with the group rather than experiencing alone. The typical example of regret aversion related to errors of omission involves an investor who purchases a “hot" security (one that has risen in value and touted by other investors and financial media). Most of the time this “hot" security is purchased not based on fundamentals, diversification benefits or for any other rational grounds. Rather, it is purchased because the investor fears experiencing the regret that would result if the security continues to go up and they don't reap the benefits. This type of investment behavior displayed by mass creates the herding effect. The herding effect was the major contributor to the inflating of technology bubble in the early 2000s. The crash that followed, investors held on to the losers for too long due to regret aversion associated with errors of commission.

Happy investing!

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com