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Well-informed, rational decision making can be a path to better investment performance. Learn to recognize your biases, control your emotions, and reap the rewards.

Personal finance

Explore the Link Between Investment Performance and Rational Decision Making

  • Brian D'Orazio
  • 9/13/2018

Today’s equity markets are at some of their highest levels since the end of the financial crisis in 2009. In fact, the S&P 500 Index, a broad mix of U.S. large cap stocks, is up nearly 300 percent from March 2009 through June 2018. Many other risk assets have also done exceedingly well during this same time period.

S and P Price Index 1997 June 2018

Like many investors, you have probably participated in this growth and seen the values of your investment accounts rise. You’ve probably felt pretty good as these balances have increased and allowed you to take a step closer in achieving your financial goals such as retirement, college education for your children, charitable giving, or other legacy goals.

In reality, the “average” investor does not keep much of his/her profits over the long run. We’ve discovered five common investor biases and emotions that can lead to below-average returns. If you can move past these behaviors, it may be possible to leave the “average” investor behind.

20 Year Annualized Returns by Asset Class 1998 2017

Emotional investing can lead to below-average returns

We’re all human, and we have all experienced the emotional ups and downs of investing (especially in periods of high market volatility). But rational decisions based on solid information will generally win the day. Be on the lookout for these five mental short-cuts:

1

Loss aversion — Most investors have stronger feelings of pain over investment losses than feelings of joy over investment gains. As a result, an investor may be more willing to sell a security at a gain and hold on to a security with a loss on the hope that the losses can be recovered. Many times a long-term buy-and-hold strategy is prudent as these assets may, in fact, bounce back. However, sometimes it may be best to cut ties and redeploy.

2

Anchoring — Anchoring occurs when an investor relies too heavily on an initial piece of information (the anchor) when making investment decisions and does not consider new information or facts that have become available. As a result, investors may tend to hold investments for a longer period or expose themselves to unnecessary risk.

3

Hindsight bias — Many investors believe that an asset will perform well in the near future because it has performed well in the recent past. As a result, some investors are constantly chasing returns. If we reflect on this, it is actually counterintuitive. The number one rule to investing is buy low and sell high. Take a look at the S&P 500 chart above. If you have not owned the S&P 500 Index over the last nine years, is now the time to buy after it is 300 percent more expensive than it was nine years ago?

4

Confirmation bias — This is the act of seeking information to validate your original decision. Let’s assume that at the initial time of implementation, your research and thesis for a specific investment was sound. Time has now passed, and as a result, the economic environment has changed. Instead of analyzing this new information with an open mind, many investors seek information that confirms their original thesis while ignoring data points that counters their bias. As a result, they do not make changes and could potentially expose their portfolio to additional risk.

5

Regret aversion bias — When evaluating investment options, many investors think about how they would feel with the worst possible outcome, and then make a decision based off of that feeling. This decision-making process often leads to choices that are not optimal; many will choose the option that minimizes regret. Emotions like fear or greed often impact our judgement as opposed to considering the likelihood and effects of all outcomes. Regret aversion generally leads to risk aversion and a portfolio that has less risk than what may be required to reach your financial goals.

Three steps to rational investing

The majority of investors experience the feelings just described. But it is hard to make rational decisions when our emotions are involved. Here are few recommendations to help you muscle the emotions aside and make better choices:

1

Be mindful of your emotions — In the event that there is market volatility and you begin to see the values in your account oscillate, take a moment to reflect on your emotions. Turn inward. What are you feeling? Why do you believe you are feeling this way? If you have experienced these emotions revolving around investing before, what did you do and what happened the last time? Now might be the time to pause and speak openly with a family member, close friend, or trusted wealth advisor.

2

Develop a written financial plan — Developing a financial plan and monitoring your progress helps create discipline. Your plan will help keep you focused and allow you to make informed financial decisions based on facts during periods of volatility and uncertainty. Discipline will improve your odds of reaching the financial milestones that lie ahead.

3

Periodically review your investment portfolio — This may be an appropriate time to review your investment portfolio to ensure you are assuming the appropriate level of risk. There may be an opportunity to reduce the overall risk in your portfolio by considering new risk premiums and alternative investments to further diversify your holdings.

How we can help

CLA private client tax professionals and wealth advisors understand your concerns and the decisions you face as an investor. We can provide you with objective advice, deep resources, and a commitment to helping you attain financial goals.

  • Brian D'Orazio
  • Principal
  • CLA Greenwood Village
  • CliftonLarsonAllen Wealth Advisors, LLC