A: By simply repeating investing behaviors that resulted in good outcomes for us in the past, and avoiding those that resulted in poor outcomes, we’re potentially eliminating important information that could help future investment performance. This is the primary issue with relying on our personal observations and experiences to form return and risk expectations and building portfolios.
For example, an individual who has only experienced poor stock market returns may cut down his retirement contributions to the point that he ultimately falls short of his retirement goals. Today’s younger generations, who over the past 15 years have seen two big stock market crashes, may be especially susceptible to underinvestment in risky assets if they base their investing decisions solely on their own personal investment experience.
Q: What steps can investors take to mitigate the potential adverse impact of this bias on their portfolio positioning and performance?
A: Key here is broadening one’s horizons, starting with an awareness of our tendency toward the personal experiences bias. More specifically, individual investors and advisors would want to consider deliberately lengthening the time period on which they are basing their return and risk assessments to include different macroeconomic and market scenarios.
In addition, given the dangers of spot estimates, portfolios should be scenario and stress tested for different kinds of environments, and the data sources used to make assessments should incorporate a broad array of information, ranging from macroeconomic to company specific data.
I also advocate using a rules-based or systematic investment methodology, whether simple quantitative screens or full investment models built to predict fair values, to help construct a portfolio. This approach can potentially draw attention to, and help weed out, behavioral investment biases.
Sources: Studies linked to throughout the post.
Nelli Oster, PhD, is a Director and Investment Strategist in BlackRock’s Multi-Asset Strategies Group. She holds a BSc (Hons) in Management Sciences from the London School of Economics and a PhD in Finance from the Stanford Graduate School of Business, where her dissertation focused on behavioral finance.