Many finance experts assume that investors act rationally to maximize profits while minimizing risks.
But as we write in our new Market Perspectives paper, investors routinely make a number of irrational missteps that can be explained by a growing body of behavioral finance research, which studies how people make money-related decisions. Here’s a look at three of these common investing bad behaviors.
1.) Stock market avoidance. Many people avoid risky assets like the stock market despite the high cost of staying out of such investments, particularly in the current, low-yield environment. Consider, for example, that adjusted for inflation, the return on cash left in a bank account was negative for 2012. In comparison, world equity markets as measured by the MSCI All Country World Index returned 13.4% in US dollar terms during the same period.
Why do some investors shy away from stocks? Behavioral finance studies have found that investors are roughly twice as sensitive to losses as they are too gains. In addition, people tend to evaluate gains and losses over a relatively short time horizon that may not be in sync with the longer horizon over which investment goals are expected to be achieved. This extreme fear of losses in the near term, combined with people’s tendency to look at each investment in isolation, helps to explain low stock market participation rates.
2.) Insufficient Diversification. Another common investor mistake is to have an under diversified portfolio. In a 1991 to 1996 study of the customers of a large US discount brokerage, more than 25% held only one stock and more than 50% held three or fewer stocks. However, a well-diversified portfolio should include at least 10 to 15 stocks, which only 5% to 10% of the investors held in any given period. And generally speaking, the more diversified portfolios performed better: the most diversified investor group in the study earned more than 2% a year higher returns than the least diversified group.