Following Your Head and Your Heart: A Recipe for Poor Investment Returns

In a prior post, we alluded to the chronic failure of individual investors to earn investment returns greater than that of the market as a whole over the long term.  Given how many individuals are still tempted to try to be the exception to this rule, however, we would like to explain why this is the case and how working with a financial adviser can help.

Don’t Trust Your Head.  Unfortunately, the main culprits sabotaging your individual investment efforts are:  your head and your heart.  The field of behavioral finance has uncovered several cognitive biases that interfere with successful investing strategies, especially for investors trading in individual stocks, and we’ve observed this with real estate investing as well.  For example:

– Overconfidence bias can lead investors to think they have the magic touch after one or two profitable investments,

– Clustering illusion can cause one to see patterns (and act on them) where the occurrences are actually just random (e.g. that the stock market usually declines after an AFC team wins the Super Bowl)

– Familiarity bias can lead one to skew one’s portfolio toward companies or sectors/regions that are more familiar and thereby under-diversify,

– Loss aversion can result in holding an investment longer than one logically should because of unwillingness to realize a loss on it and hope that it will rebound (as Mike always says, “Hope is not a strategy!”), and

– Anchoring bias can cause one to discount the significance of new information about an investment because of an investor’s beliefs about what the price of the investment “should” be, the initial expectations he had when he bought it, etc.

Don’t Trust Your Heart.  Even when investors avoid dabbling in individual stocks and follow a more passive investment strategy, their emotions can significantly hamper their investment returns by influencing when and how they invest.  Investor emotions generally fluctuate based on the market cycle, as shown at left.  If investors act on those emotions, buying when they are feeling elated and selling when they are afraid (about the performance of a particular stock, an asset class, or the market as a whole), that often translates into buying at the peak of the market when prices are highest and selling when prices are lowest, i.e. the opposite of the ideal investment strategy.  In a recent US News article on the “7 Bad Investing Habits That Are Holding You Back,” Jerry Chafkin, the chief investment officer at AssetMark, compares this reactive behavior of individual investors to that of an impatient driver, stuck in traffic and envying other lanes that appear to be moving smoothly.  He explains, “[The temptation to get in the other lane] won’t necessarily get you to your destination faster, but the urge is powerful.”  Emotions tend to drive investors to switch lanes (into different stocks, asset classes, or cash) often at the worst possible time, when their fear is most intense.

We are simply not wired to be good investors.  While we love to buy other products on sale (new car, clothes, etc.), we do not feel the same way about our investments.  Hiring a financial adviser, especially one with a clearly outlined and faithfully implemented passive investment strategy, can remove much of the negative influence of emotional and cognitive biases from your investment performance.  Commitment to a long-term “buy and hold” investment strategy (with a fixed asset allocation and regular portfolio rebalancing) will reduce many of the cognitive biases over which individual investors stumble.  And, the fact that the strategy will be implemented by a relatively objective third party ensures that emotions will play less of a role. 

Don’t trust your heart, or even your head.  Hire an adviser, who will feel less emotional about your investments, and trust in a disciplined strategy instead.