Behavioural Investing : The Key to Growing your Wealth
Few weeks back J.P. Morgan came out with a study which showed that an average investor earned just 3.6% returns over the last 20 years as compared to S&P 500 which had 9.5% annual returns and even the 60/40 portfolio giving 7.4% returns.
Can you imagine your portfolio underperforming the benchmark index by that margin ?!
Another interesting study that comes to my mind is about famous fund manager Peter Lynch. He ran Megellan Fund for 13 years, producing annual returns of 29% during which S&P did only about 14%.
After he retired, a study was conducted on the returns of individual investors. We would expect that the investors in that fund would have made a killing. But that was not the case.
Average investor in the fund actually lost money. People were investing in the fund right after fund gave phenomenal returns for few years, the expectations are sky high from the fund, and when the fund is unable to deliver that, they would exit. And they would keep repeating the same.
What causes this tendency among investors, that leads to performance gap?
One thing became clear looking at these two studies was that investors don’t need another alpha generating product when they are clearly unable to realize the index returns which should be a simple job.
Also the reason for this underperformance is the behavior gap. The ideal behaviour vs the actual investor behavior is the behavior gap.
Our brains’ natural tendency is to make decisions using emotions. However, we all would rather think that the only thing that influences our decisions is reasoning and logic.
Our brain is hard-wired to do certain things. Evolutionary psychologists argue that although you can remove a person from the Stone Age, you cannot remove the Stone Age from the person.
For example, we are hard wired to stay with the herd. A few thousand years ago this would have been the logical thing to do because it was safer to stay in herds, but we all know that in investing herd behavior is the major cause of underperformance.
Thus it becomes super important for investors to understand the common biases we have while making investing decisions and how to deal with them.
Most common Investor Biases
- Overconfidence
There have been tons of studies in academia which have shown that human beings are inherently overconfident. And this overconfidence bias affects us in many ways like trying to pick individual stocks and trying to time the markets.
- Myopic Loss Aversion
Focusing on short-term rather than on long-term and anchoring our decision making on most recent data are common problems we face because of this bias.
- Halo Effect
We all believe that a fund manager with certain personality traits like more outspoken or someone with good storytelling/sales skills would be a better fund manager but in reality these traits have no effect on the performance of the fund.
- Prospect Theory
This is the reason why we tend to hold to our losing trades for long and are too eager to book our profit making positions.
- Representativeness
Great companies make for great investments is a belief we all have because of the representativeness bias. In reality a great company is a great investment only if the entry price is right.
While these are the most common biases, there are many other biases that impacts our decision making and we will become better investors if we are aware of these biases. The awareness of these biases will not only help us in investing but in life in general.
Looking to learn more about Behavorial Investing?
Understanding these biases have helped me personally in my investing journey over the last 2 decades.
Join us this Sunday, 5th November at 12:30PM for a Live Ask Me Anything Session on smallcase’s YouTube channel. We will be discussing:
- Understanding Common Behavioral Biases
- Managing your Emotions When Investing
- Case Studies & Examples of Mastering Behavioral Investing
My aim is to share my learnings as well as insights from research. It will be great if you all could share your learnings and also share with me any questions that you might have related to these topics during the live event. I will try to answer them to the best of my knowledge.
