To Err Is Human

A version of this article was published in the April 2019 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.

Risk is anything that could threaten your ability to achieve a goal. Many portfolio risks that capture our attention are those that we can’t control. How will stock market movements, changing interest rates, or the price of oil affect our investments? Investing is a probabilistic exercise. The key to increasing your odds of investment success is to make sound decisions. Most investors could improve their portfolio risk management by turning the spotlight on themselves and recognizing when their behavioral biases may lead to bad decisions that hurt performance.

Investors should prioritize managing portfolio risks from their behavioral biases because these risks:

1. Are within their control;
2. Are likely to occur;
3. Have an meaningful impact on portfolio returns.

Identify. Adapt. Overcome. The latest CFA field guide[1] of behavioral biases groups them into two camps: emotional biases and cognitive errors. The first step to overcoming bad investment decisions from behavioral biases is to determine which bias you are more susceptible to.

Emotional biases stem from impulse or intuition and lead to faulty reasoning owing to the influence of feelings such as fear, greed, or remorse. These biases are more difficult to overcome than cognitive biases because it’s tough to control emotional responses to the experience of losing or making money.

Cognitive errors stem from faulty information processing or recall. These are split between two types. First is belief perseverance, which is the tendency to irrationally stick with current beliefs. These decision-making errors could stem from selective exposure, perception, or retention of new information. Processing errors are the second type. Instead of failing to adjust to new information, these errors are caused by shortcuts that we use to make decisions quickly. Cognitive errors represent the limits of the human mind and tend to be easier to correct than emotional biases.

Exhibit 1 shows the taxonomy of common behavioral biases.

All investors will exhibit some of these biases at some point in their investment career. While it’s hard to avoid these biases, it’s important to take steps to mitigate their impact.

Managing Emotional Biases Emotional biases are difficult to manage because they stem from impulse rather than miscalculation or interpretation of information like cognitive biases. For example, fear of pain from investment losses could lead us to sell out of the market after it crashes. This is often a poor decision because valuations are more attractive following market downturns, which can lead to better future returns. On the flip side, fear of missing out could induce counterproductive performance-chasing. The decision to buy once prices are already high is another suboptimal investing decision because high prices can lead to less attractive valuations and returns going forward. In any case, doing what you wish you would have done in the past is rarely a recipe for investment success.

Morningstar’s "Mind the Gap" study quantifies the phenomenon of investors behaving badly likely because of emotionally fueled decisions. The latest study found that the returns experienced by the average mutual fund investor lagged the asset-weighted return of the same funds by 1.37% annually over the past 10 years through March 2018.[2] This gap is simply the fund returns that investors missed out on owing to poor investment timing decisions, likely performance-chasing.

Overcoming emotionally driven decisions is difficult, but you can set yourself up to reduce the likelihood of making these mistakes. Investing to your "optimal" risk-based asset allocation isn’t useful if you can’t stick with it during rough patches in the market. Depending on your level of wealth and standard of living, emotional biases may be best managed by modifying your asset allocation. For example, you could shift toward an asset allocation that’s more conservative (for example, tilting more heavily toward bonds and away from stocks) than the risk level that you ought to be able to tolerate. The higher your level of wealth and lower your standard of living, the more cushion you have to deviate from your optimal asset allocation. Modifying your asset allocation to adapt to your emotional biases could improve your investment outcome because you’re more likely to stick with a more conservative allocation in turbulent times.

Overcoming Cognitive Errors Cognitive errors stem from poor information processing and overconfidence in our ability to predict or influence market outcomes, leading to bad decisions. For example, resisting the urge to trade when faced with new information can be tough to overcome. But you're likely better off not trading based on "new" information that you read in Barron's or hear on CNBC. Since everyone has access to that news, it probably won't lead to market-beating performance. Frequent trading can lead to excessive transaction costs or realized taxes, which detract from performance.

If you find yourself trading frequently, remember there’s always someone on the other side. Consider what they might know that you don’t. It should also be sobering that most professional money managers, with all their time and considerable resources dedicated to their craft, don’t beat the market. Morningstar’s Active/Passive Barometer shows that most actively managed U.S. fund fail to top their average passively managed peer in their respective Morningstar Category. Exhibit 2 shows the success rate of actively managed funds' average return over their passive category peers over varying look-back periods as of Dec. 31, 2018.

Cognitive errors can lead to the impression that we can take actions to beat the market, even when the odds are long. The good news is that cognitive errors are easier to address than emotional biases because they represent limits in logic or calculations rather than deeply seeded impulses. Checking your decision-making logic and finding gaps in thinking are often the best ways to avoid cognitive errors. The following strategies may help mitigate their effects.

1. Hit pause. Often times when making an investing decision, the benefits of waiting a day or a week to make a decision outweigh the penalty for not acting fast. Slowing down the decision-making process will allow the time to collect necessary information to make a more informed decision. Sometimes, the best thing to do is nothing at all.
2. Keep an investment journal. Documenting your thought process leading up to an investment decision can help keep yourself in check. Use consistent sections in your journal to create a time series of decisions to find where you consistently make strong or poor decisions.
3. Have a devil's advocate. Find a friend, financial advisor, or family member to check your investment logic and highlight your blind spots. The goal here is to help strengthen your thinking before making the decision. The best candidates for this role are those that exhibit sound logical thinking, aren't afraid to point out when you're wrong, and are willing to put in the time. This is a two-way street. An investing partner will appreciate it if you exhibit the same characteristics when serving as a devil's advocate for them.

Correcting Bad Behavior Investors should prioritize the risk of bad behavior on their investment decisions because its within their control, likely to occur, and can have a on meaningfully impact the odds of long-term investing success. Recognize that you're likely to be prone to both emotional and cognitive biases. For emotional biases, improve your odds of investing success by considering a more conservative asset allocation that you can stick with during rough markets. When dealing with cognitive errors, self-reflection is key. Consider sleeping on it before making a decision, keep an investment journal, or use a devil's advocate when making an investment decision. Better decisions usually lead to better investment outcomes. Don't let your behavioral biases torpedo your portfolio.

[1] Pompian, M.M. 2011. "The Behavioral Biases Of Individuals." CFA Institute. 2011. https://www.cfainstitute.org/membership/professional-development/refresher-readings/2019/behavioral-biases-individuals

[2] Kinnel, R. 2018. "Mind the Gap 2018." Morningstar. https://www.morningstar.com/lp/mind-the-gap?cid=RED_RES0002

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