Overconfidence and illusions of control, among other issues, can complicate the investing lives of accumulator-type clients.
This month's article is the 12th in a series called "Deep Dives into Behavioral Investor Types." This series is intended to help advisors create better relationships with their clients by deeply understanding the type of person they are dealing with from a financial perspective and adjusting their advisory approach to each type of client.
As we learned in the last series, there are four behavioral investor types (BITs): the Preserver, the Follower, the Independent, and the Accumulator. If you missed any of these articles, you can find them in my MorningstarAdvisor.com archive.
We will discuss each BIT in a series of three articles:
Part I will be a diagnosis of each BIT and discussion of its general characteristics.
Part II will be a deep dive into the biases of each BIT.
Part III will cover how to create a portfolio for each BIT.
This article is Part II of the Accumulator BIT. (Click here to see Part I.)
A Deep Dive on the Accumulator
The biases of Accumulators tend to be emotional--relating to how people feel--rather than focusing on cognitive aspects--relating to how they think. The biases of the Accumulator BIT are overconfidence, illusion of control, affinity, self-control, and outcome.
I have found that two of these five biases have a substantial impact on Accumulator behavior: overconfidence and illusion of control biases.
Bias Type: Emotional
Overconfidence is best described as unwarranted faith in one's own thoughts and abilities. Overconfidence manifests itself in investors' overestimation of the quality of their judgment. Many aggressive investors believe they have an above-average aptitude for selecting investments; however, similar to other investor types, they get agitated and nervous during times of market stress and make less-than-optimal decisions.
For example, in the early months of 2009 more than a few overconfident, aggressive investors were unable to stomach the volatility arising from the financial crisis--selling at the wrong moment, as stocks just were reaching their low point. Those who were advised to stick with their plans, however difficult it was, and had the foresight and fortitude to ride out the volatility, saw their portfolios bounce back nicely. In retrospect, of course, this was an incredible buying opportunity. Advisors need to be aware of the situations in which clients may change their portfolios at the wrong time only to see the opposite of what they had intended to do occur.
People who have been successful in business and other pursuits tend to believe in themselves; this is how they became successful in the first place. But overconfidence can be a dangerous thing in the investing world. Markets can and do stay irrational for long periods of time. Just because the price of a security should be higher or lower doesn't mean it will change in the short run.
A classic example of investor overconfidence is the case of the former executive or family legacy stockholder of a publicly traded company such as Enron or Lehman Brothers. These investors often refuse to diversify their holdings because they claim insider knowledge of, or emotional attachments to, the company. They cannot contextualize these "stalwart" stocks as risky investments. However, dozens of once-iconic names in U.S. business, such as those named above, have declined or vanished.
Illusion of Control Bias
Bias Type: Cognitive
The illusion of control bias occurs when people believe that they can control, or at least influence, investment outcomes when, in fact, they cannot. Aggressive investors who are subject to illusion of control bias believe that the best way to manage an investment portfolio is to constantly adjust it. For example, trading-oriented investors, who accept high levels of risk, believe themselves to possess more control over the outcome of their investments than they actually do because they are pulling the trigger on each decision.
Illusion of control bias can lead investors to trade more than is prudent. Researchers have found that traders, especially online traders, believe themselves to possess more control over the outcomes of their investments than they actually do. But an excess of trading ultimately results in decreased returns.
Illusions of control can also lead investors to maintain under-diversified portfolios because they concentrate their bets on only a few companies. Some investors hold concentrated positions in stocks because they gravitate toward companies over whose fate they feel some amount of control. That control proves illusory, however, and the lack of diversification hurts their portfolios.
Illusion of control bias contributes, in general, to investor overconfidence. Investors need to recognize that successful investing is usually a probabilistic activity. A good starting point is to take a step back and realize how complex U.S. and global capitalism actually are. Even the wisest investors have absolutely no control over the outcomes of most of the investments they make.
Just because you have deliberately determined to purchase a stock, do you really control the fate of that stock or the outcome of that purchase? Rationally, it becomes clear that some correlations are arbitrary rather than causal. Don't permit yourself to make financial decisions on what you can logically discern is an arbitrary basis.
Another recommended step is to seek contrary viewpoints. As you contemplate a new investment, take a moment to ponder whatever considerations might weigh against the trade. Ask yourself: Why am I making this investment? What are the downside risks? When will I sell? What might go wrong? These important questions can help you to test the logic behind a decision before implementing that decision.
Overconfidence and illusion of control are two highly relevant biases for the Accumulator. However, there are other biases that can be found to occur with Accumulator BITs with some regularity: affinity, self-control, and outcome.
Bias Type: Emotional
Affinity bias refers to an individual's tendency to make irrationally uneconomical consumer choices or investment decisions based on how they perceive that a certain product or service will reflect their beliefs or values. This idea focuses on the expressive benefits of a product rather than on what the product or service actually does for someone (the utilitarian benefits). A common example of this behavior in the consumer product realm is when one purchases wine. A consumer may purchase a fine bottle of well-known wine in a restaurant or wine shop for hundreds of dollars to impress their guests, while a bottle that costs much less could be equally delicious but would not convey the same status.
Bias Type: Emotional
Independent BIT investors with a conservatism bias tend to cling to what they already know to be true at the expense of acquiring new information. For instance, suppose an investor named Bill receives some bad news regarding a company's earnings, which contradicts another earnings estimate from the month prior that he relied on to invest in the company. Because he has a conservatism bias, Bill underreacts to the new information, holding on to the original estimate instead of acting on the updated information. As a result, he ends up holding on to a stock that he's going to lose money on because he is stuck in his prior beliefs.
Bias Type: Emotional
Outcome bias refers to the tendency of individuals to decide to do something--such as make an investment in a mutual fund--based on the outcome of past events (such as returns of the past five years), rather than by observing the process by which the outcome came about (the investment process used by the mutual fund manager over the past five years). An investor might think, "This manager had a fantastic five years, so I am going to invest with her," rather than understanding how such great returns were generated or why the returns generated by other managers might not have had such good results over the past five years.
Next month will be the 13th article in the "Deep Dives into Behavioral Investor Types" series and the third on the Accumulator BIT.