Over the last 30 years, the S&P 500 Index (SPX) has averaged a 9.96% annual return. During that same time period, the average equity fund investor has earned an annual portfolio return of 4.92%.1 What does that mean from a dollars and cents standpoint? A hypothetical $100,000 portfolio that tracked the SPX exactly would today be worth more than $1,726,000. The average investor’s $100,000 portfolio, however, would have only grown to a little more than $422,000.
It's a massively different outcome. And much of the underperformance is directly attributable to certain behavioral biases that cause investors to make bad decisions about money and investing. By recognizing and understanding the following biases, you’ll have a much better chance to avoid them and stay on track towards your long-term goals:
1. Status quo bias: Preferring the familiar to the unknown. When you stay on the sidelines in anticipation of some potential geopolitical incident or crisis, for example, you may feel as though your protecting your money from the unknown. But keeping your assets in cash actually means you're actively choosing to sacrifice long-term returns for short-term comfort.
* You rarely adjust your 401(k) holdings or contributions
* You keep hanging on to underperforming investments
2. Loss aversion: Feeling the pain associated with losses more intensely than the joy associated with gains. For example, have you ever spent hours turning the house upside down and driving yourself crazy in the process as you search for a misplaced $20 bill? Now compare that to the brief thrill experienced when you find a $20 bill as you walk down the street. Is the former more intense than the latter? That’s loss aversion.
* You err on the side of caution
* You miss out on potential long-term opportunities due to fear of short-term losses
3. Present bias: Placing significantly greater value on something received now compared to something received in the future. Think of how purchasing an item now, such as a new car, feels a lot better than investing that money for your future. Studies over the years have shown that given the choice, a majority of people would opt for $100 today rather than $1000 five years from now. The immediate gratification that comes with buying things can be far more compelling than the larger rewards that come in the future by investing.
* You delay saving for the future
* You take on debt to finance current needs
4. Recency/availability bias: Placing greater importance on recent events rather than long-term trends—especially when the event is emotionally impactful. In 2010, for instance—when the memory of the market's 37% drop during the 2008 economic crisis was still fresh in people’s minds—Franklin Templeton surveyed investors as to whether the thought the market was up, down, or flat in 2009. Even though the Dow Jones Industrial Index (DJIA) had climbed nearly 23% that year, two-thirds of investors believed the market was either down or flat.2
* You immediately sell out of the market after a steep drop
* You wait to get back into the market until it is near a peak
5. Confirmation bias: Focusing on any information that supports your assumption, while discounting any information that contradicts your belief. For example, you might hear about a particular stock that your wealthy friend is in love with. When researching it as a possible investment, you pay attention to positive articles about the company’s vision, sales growth, and cash flow. However, you skim past red flag articles pointing out that a much larger competitor has just entered the market.
* You develop a positive feeling about a certain stock/sector and subconsciously seek out information that supports this opinion
6. Clue-seeking bias: Using irrational reasoning when trying to make rational decisions, especially when the decisions are complex. One common example of this can be found in 401(k) investors who when provided with a list of mutual fund choices will frequently choose the first fund on the list, assuming it must be recommended because of its placement.
* You are drawn to a certain investment because of its name or some other non-material quality
7. Optimism/overconfidence bias: Estimating higher-than-average odds of good results. For example, if you were to ask a room full of people to rate their skills as a driver, far more than 50% (if not most) are likely going to grade themselves as above-average even though it’s a statistical impossibility.
* You avoid contingency planning with life insurance or long-term care insurance assuming that bad things won’t happen to you
8. Herding bias: Following the herd, even though they may be acting irrationally or counter to your best interests. Every time there’s a new investment trend or hot stock, it can be tempting to just follow the masses. If it works out, everyone is happy. And if it doesn't work out—well, at least we’re all in it together, right? When it comes to investing, however, going against the grain is often far more rewarding.
* Despite your own research and intuition, you still find yourself sometimes buying high and selling low along with the crowd.
Improving your investment discipline and your long-term financial outlook starts with self-awareness. By understanding these inherent biases we all fall victim to from time to time, you’ll be able to anticipate and avoid them. A few sure-fire ways to overcome biases include:
- Making a conscious effort to always gather empirical data rather than solely relying on your instincts;
- Actively seek out any and all evidence that runs counter to your basic assumptions;
- Always try to learn from your inevitable failures, so you’ll understand how to avoid those situations in the future;
- At all costs, steer clear of financial information overload or you’ll find yourself in a situation of ‘paralysis by analysis’; and
- Ask your Truist Wealth advisor to work with you to help conquer these biases by staying focused on longer-term financial goals.