BEHAVIORAL FINANCE: WHY INVESTORS UNDERPERFORM THE MARKET

By: Terry Donahe

How is that the Standard & Poor’s 500 index can turn in a return of 11.80% for the period 1987-2006 and yet individual stock mutual fund investors earned a dismal 4.30%? This is not an anomaly. Historical data indicates that individual investors consistently and significantly underperform the returns of the overall market.

Behavioral finance focuses on the role that emotions and other psychological factors play in investment decisions. It identifies several human tendencies that cause investors to abandon rational thinking and result in bad decision making. In Part 1, we reviewed two examples of this phenomenon: Anchoring and Mental Accounting. Let’s continue our exploration.

CONFIRMATION BIAS: Investors often see what they want to see, rather than broadly evaluating a product, an opportunity or a situation. The reason for this is that they have predetermined a decision. Their efforts to gather additional information prior to executing the decision are in reality a mere formality. The only information that garners serious attention is that which supports the decision. Information that contradicts the decision is downplayed or dismissed. For example, an investor learns of a “hot stock” that is purportedly headed for the moon. He jumps on the internet and does a Google search. While he finds a real mix of both negative and positive information about this stock, he ignores the red flags and he uses only the positive data to support his decision to purchase the stock.

HINDSIGHT BIAS: Some investors believe that significant past events or circumstances that appeared at the time to be unexpected or even shocking actually could have been anticipated. These people look back and find various pieces of anecdotal evidence that would allow an astute observer to predict the event that occurred. This conviction emboldens the investor and causes her to believe she can identify opportunities before the market itself realizes them. For example, there is a significant contingent of self appointed prognosticators who claim that the current crisis in the credit markets and the related housing slump could have been anticipated well before they became such a drag on the financial markets and the overall economy. These folks would have us believe that it’s often possible to earn substantial profits by acting ahead of the market. The problem with this thinking is that, if such problems had been diagnosed and defused in their infancy, they most likely would have been.

There are several other anomalies that researchers have identified as they study investor psychology. We will continue to bring these to light with the hope that they will enable investors to make better decisions. For it is clear that investors underperform the market primarily because they make poor decisions.

Terry Donahe is a CERTIFIED FINANCIAL PLANNER™ who works with affluent individuals and families. His firm, Cascade Wealth Management, is a fee only Registered Investment Advisory firm located in Lake Oswego, Oregon. You may learn more about Terry and his firm at www.cascadewealth.com. Terry can be reached at (503)675-4381 or by email at terry@cascadewealth.com.

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