Content provided by Joe Smith, CFA, CLS Senior Market Strategist
2016 is now in the books with investors clearly doing better than they may have expected at the start of last year. Global markets were up. Value investing is back in vogue again. Economic growth seems to be showing signs of improvement both at home and abroad. Investors have some data to suggest they should be more optimistic, confident, or certain about the future.
Investors with these characteristics can also tend to be prone to falling into systematic biases that can result in disaster if they are not careful. Why? Because the human mind plays tricks on all of us when faced with complex decisions in the face of events that are not entirely known today. Investor biases can lead to less than optimal decisions made by advisors and their clients that can impact the ability to meet their long-term goals. Here are three biases that have been identified in academic literature over the years that advisors and their clients should be mindful of when making investment decisions.
- Overconfidence bias: Overconfidence involves the allusion of having well-calibrated expectations about what is likely to happen going forward in the markets. Many market pundits tend to give examples of their expectations for the Dow Jones or the S&P 500 prediction over the course of the year. Unfortunately, overconfidence can lead to much larger surprises versus their expectations (on both the upside and the downside).
- Manage you and your client’s expectations and avoid making overconfident statements.
- Make clients aware of the uncertainty associated with their investment decisions.
- Optimism bias: As human beings we tend to be wired to focus on the positives in life and less so on the negative ones. This tends to result in people’s beliefs being skewed in the direction of optimism. Optimism can be harmful because it can result in someone underestimating the likelihood of bad outcomes that are not in their control – specifically the movement in the markets. Optimism can also result in people believing events of chance can be thought of as games of skill that can be fully controlled.
- Communicate realistic odds of success to your clients.
- Keep a list of past recommendations that were not successful.
- Don’t focus exclusively on the upside associated with past performance.
- Overreaction to events of chance: Have you ever found yourself looking for a pattern in what appears to be a random sequence of information? Human beings often look to determine the relationships in outcomes that in many cases are actually random. Investors are guilty of this when they translate a short-term set of outcomes into a long-term trend without any other evidence to support their claim.
- Make a list articulating your reasoning or rationale behind making an investment decision.
- Ask yourself if your decision is based on long-term objectives or in response to short term trends that may in fact be random.
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice.