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By Jason Stipp | 07-19-2013 04:00 PM

How to Avoid--and Profit From--Common Behavioral Mistakes

Investors can boost their outcome by resisting behavioral pitfalls, avoiding hyped stocks, and looking for underappreciated signals, says Fuller & Thaler director of research Raife Giovinazzo.

Stipp: Raife, I'd like to get some ideas for individual investors on how they can avoid some of the mistakes that your fund seeks to profit from. What kinds of guardrails can they put up so they aren't making these mistakes?

Giovinazzo: So I would say there are two areas in which individual investors can apply some of the behavioral finance lessons. One is in their portfolio, and the second is in their trading.

In the portfolio, I would say there are three classic errors. The first is individuals often own too much of their own company stock, and that's due to a familiarity bias that comes from the affect of, you like things you're more familiar with. People do this: They tend to buy more stocks that are centered in their hometown. They tend to buy stocks that are in their states, stocks that are in their own country. And in particular they often buy the stocks that they themselves work for. That can be very dangerous. First of all, your human capital is intimately tied up with the success of that stock, but also it can lead to a lack of diversification.

The second classic error is known as the endowment effect, and that is, people tend to value things they have more than the things that they might get. … There is some research on this, many classic experiments, but where it applies in the stock market is that perhaps people inherited something from when their grandmother passed away, perhaps they've had a stockholding that's grown to be a very large percentage of their portfolio, and they don't get rid of it because they fell like, well, I have it, and they're overly attached it, and that can lead to very lopsided portfolios as well. You can see how that could interact with the company stock also.

The third classic error in portfolios is the disposition effect. That is holding on to losers too long, and the reason is, people don't like acknowledging a mistake, and they sort of think incorrectly that if they just never sell it, they don't have to book the loss. Conversely, people tend to not hold on to their winners long enough. They like to be able to say, I checked the box, I made a profit, that's good. And that's something that people need to watch out for. I might add that the disposition effect goes completely against tax-planning as well. People actually would benefit perhaps from selling some of their losers, but they don't because of this emotional reason.

On the trading side, I think the three most common dangers are, first of all, a confirmation bias. People, when they are coming up with ideas--and we all do this--they tend to look for information that will confirm their starting hypothesis. It's usually very easy to find evidence to support anything that you want. What you really should be looking for is disconfirming evidence--evidence that says, your hypothesis is wrong. When you are subject to the confirmation bias, and you just look for evidence that supports your idea, you're likely to do a lot of trading that isn't well-founded.

A second common error in trading is seeing patterns where they aren't really there. This is sometimes called the small sample effect. … If you go back to caveman times, so to speak, it was very useful to notice, hey, one guy ate a berry and he got sick; I shouldn't eat that berry. You very rapidly form patterns that are based on only one or two anecdotes. But in the stock market that kind of behavior can be very damaging and again lead to overtrading.

The third area in trading that I think often can mess up individual investors is checking your portfolio too often. There is a fancy word for the problem called "myopic loss aversion." What it basically means is, people, we found experimentally, experience more pain from a loss than pleasure for the corresponding gain in the other direction. So if you check your portfolio every day, every minute, the losses and the gains on average kind of balance out, but the losses are much more painful. If there is too much checking of the portfolio, that can often lead to overly risk-averse investing.

So I think those are some of the things that people can do that help individual investors avoid some of the errors that we think are common in stock analysts, and even professional portfolio managers.

Stipp: Let's say that I think … I know it's difficult … but I think I've avoided most of those mistakes and now I'm ready to be contrarian and go out there and maybe profit from some of the mistakes that other investors make. What are some of the classic hallmarks that some of those mistakes are occurring and creating an opportunity for me, potentially?

Giovinazzo: That's, of course, what we're trying to do. We like to think we can do it better than individuals can, but I'll share the general principle.

One is, on the overreaction side, to try to avoid hyped stocks. To look for examples where people are overreacting in a positive way to a stock. Unless you think you've got a skill at timing how long the hype will continue, it's generally over the long haul a good idea to bet against those kinds of stocks.

A second example would be trying to seek some kind of signals from other informed investors that overreaction has passed. One thing we often look at--of course, many people look at this--is to look at executive buying behavior and executive share repurchases, especially on stocks that have experienced a large decline, as a sign that there was past overreaction, but it wasn't with good reason, because the people who know even more than outside investors, they see a positive signal on the stock.

The third example of ways investors can profit from the behavioral mistakes of stock market analysts and other professional investors is to try to seek surprises that are underappreciated. The kind of classic story that my co-portfolio manager tells is of a conversation on an earnings call, where the CFO said, Jack, I know your number for … next quarter's earnings seems reasonable, but I'm telling you it's just too low. There was a pregnant pause, and the analyst said, no, it's not. That's the classic case of analysts underreacting to new data, being too anchored on their own forecast, on their previous forecast. You almost never find an example that's that clear, but that's the kind of thing you want to look for. Where is there evidence that people are not reacting to the new data and too stuck in their old existing thoughts about an individual company?

Stipp: Raife Giovinazzo at Fuller & Thaler and also a co-manager on Allianz Global Investors Behavioral Advantage Large Cap Fund, thanks for calling in today. Very interesting stuff, very good insights for investors.

Giovinazzo: Thanks so much for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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