Behavioral finance concepts behind this mistake include investors’ tendency to use certain rules of thumb (for example, dividing assets evenly into funds) for allocation decisions and to opt for familiar home-market stock names that can be recalled easily.
3.) Inefficient Trading. Many investors tend to move in and out of positions in an inefficient way, reducing their potential profits. This may be because individual investors are often overly confident in their own abilities to beat the market, and thus trade excessively and hurt their portfolio performance. (Dan Morillo recently talked about overconfidence and investing in his blog post on failed New Year’s resolutions)
Investors also often make the cognitive mistake of extrapolating from past returns, buying assets whose prices have gone up in the expectation that prices will continue to increase. At the same time, people tend to be more likely to get rid of stocks that have done well in the past and to keep the losers so as to avoid the mental pain associated with realizing losses. In behavioral finance, this latter concept is known as “the disposition effect”, and it’s particularly striking considering that based on tax considerations, people would be expected to sell losers to exploit capital losses and defer taxable gains.
The good news is that you can take certain steps to possibly help mitigate the impact of these common mistakes. These include:
- To feel more comfortable about investing in risky assets, consider focusing on how one’s overall wealth is doing rather than focusing on each asset in isolation. This can help give each asset credit for its portfolio diversification benefits. In addition, consider viewing investments from a longer time horizon, which can help smooth out fluctuations in stock market performance.
- Consider increasing portfolio diversification by investing in well-diversified index funds or exchange traded funds.
- Consider rebalancing a portfolio periodically with a rules-based or systematic investment approach to help lessen investor biases.
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.