our behavioral biases play a major role in our investing success

8/2/2019 Our Behavioral Biases Play a Major Role in Our Investing Success

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Our Behavioral Biases Play a Major Role in Our Investing Success

By Larry Swedroe

The field of behavioral finance has provided us with fascinating insights into how ourbehaviors as human beings impacts investment results. Studies have helped us

understand how we hold and trade stocks and mutual funds, and show how

behavioral biases such as familiarity, overconfidence, narrow framing, trend chasing,

the lottery effect, and home bias lead to poor decision making.

Traditional portfolio choice models imply a simple investment strategy based on well-

diversified, low expense mutual funds and minimal portfolio rebalancing. Index and

other low-fee, low-turnover equity funds are cheap, convenient vehicles for individual

investors to implement such a strategy. The purpose of the study "Behavioral Biasesof Mutual Fund Investors" was to test whether behavioral biases explain why the use

of mutual funds varies substantially across individual investors and often departs from

the simple strategies suggested by classic theories.

Using a database of tens of thousands of brokerage records of U.S. individual

investors, the authors examined the effect of behavioral biases on the mutual fund

choices of a large sample of U.S. discount brokerage investors. Their basic conclusion

was that behaviorally biased investors typically make poor decisions about fund style

and expenses, trading frequency and timing -- resulting in poor performance.

The following is a summary of their conclusions:

Investors with strong behavioral biases or lack of attention to firm-specific or macro-

economic news are less likely to hold mutual funds, or select mutual funds for the

wrong reasons. When they do buy mutual funds, they trade them frequently, tend to

time their buys and sells badly, and prefer high expense funds and active funds

instead of index funds.

Biased investors are more likely to chase fund performance, casting doubt on the

idea that trend-chasing reflects rational fund selection decisions.

These decisions are suboptimal because they're associated with lower overall

returns.

The average (median) market risk-adjusted return on an investor's portfolio of

individual stocks is an unflattering -0.38 percent (-0.28 percent) per month.


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Interestingly, behavioral biases don't appear to affect the performance of index fund

holdings.

Despite the obvious diversification benefits offered by mutual funds, the proportion

of mutual funds in a typical equity portfolio that includes mutual funds is less than 24

percent.

The proportion of index funds in the aggregate mutual fund portfolio is very low, with

a mean of only 6.5 percent. However, among investors who hold index funds, the

proportion of index funds in the mutual fund portfolio is about 38 percent.

The authors also placed investors into five broad categories, or stereotypes, they

characterized as "gambler", "smart", "overconfident", "narrow-framer", and "mature."

Here are the breakdowns of these categories.

Gamblers Gamblers represent individuals who are:

Less likely to use mutual funds

Tend to select high-expense funds

Are more likely to trend-chase, and suffer significantly inferior mutual fund portfolio

performance as a consequence

Gamblers employ mutual funds less than they probably should, but, when they do,

they make poor use of them.

Smart Smart describes investors with higher income, relatively higher educational

level, and greater investment experience. It also represents individuals who are more

likely to use mutual funds and benefit from their choices by choosing funds with low

expense ratios or loads, and are less likely to trend-chase - and thus enjoy better

performance.

Overconfident Overconfident describes investors who are poor decision makers, avoid

participation in mutual funds and chase trends to an even greater degree thanGamblers. They also tend to select high expense, high load, and high turnover funds.

Narrow Framers Narrow Framers' mutual fund participation is about as bad as

Gamblers' participation, though not as bad as those in the Overconfident category.

Small holdings of mutual funds, selection of high expense funds, trend chasing and


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consequent poor performance are also evident, though milder than for Gamblers and

Overconfident investors.

Mature Mature investors participate and hold mutual funds to a greater extent than

our other stereotypes and avoid high-expense funds and trend chasing to an even

greater extent than those in the Smart category. However, there are other elements

of Mature investors decision making about mutual funds that yield significant

negatives on other performance measures, negatively impacting performance.

This study contributes to what was an already overwhelming body of evidence

demonstrating that most investors make poorly informed decisions impacted by both

behavioral biases and ignorance. The authors suggest that "given the misuse of

equity mutual funds, a public campaign to increase awareness of basic investment

principles and the benefits and pitfalls of equity mutual funds is likely to help many

types of individual investors make better decisions. Furthermore, the lack of attention

to low cost or index funds suggests more explicit disclosure of fund expenses and

turnover, perhaps even as prominent as the health warnings now displayed on

packets of cigarettes. Finally, the reliance of mutual fund investors on broker-supplied

information at the time a fund is selected and on delegated investment decisions

afterwards suggests that even more explicit disclosure of fund characteristics be

imposed on brokerage firms and fund managers."

How do you decide what stock to buy? How do you determine the best time to buy?

And once we have made the decision to buy when do we sell? These questions, and

how we answer them, are a direct result of how we frame the questions, thus directly

impacting our trading performance. Framing determines the viewpoint from which we

look at an issue, such a stock chart. Framing, in essence, acts as a filter determining

what information is important and what is not. For example, some of us tradeaccording to Elliot Wave cycles; others classical patterns; some using point and figure

charting; others Japanese candlesticks. Any one of these are neither right or wrong.

We simply create the stock chart and trade our creation accordingly. Even the rules

for entry and exit, for profit or loss, is framed within a certain set of self-created

parameters. If we have not created a frame or if the frame constantly changes to

satisfy current emotional imbalances then our performance will suffer accordingly.


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our behavioral biases play a major role in our investing success

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