Gut Instincts Can Hurt Your Portfolio

Common biases that influence investment outcomes.

Investor or financial analyst drawing projections on a glass panel
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When it comes to investing—and lots of other things, for that matter—the biggest blind spot most of us have is ourselves. The flaws so apparent in other folks tend to become invisible when they're our own. In social relations, this can be counterproductive. In financial markets, it can be disastrous.

Every year, the Boston financial-analysis firm Dalbar, Inc. publishes a report documenting how much certain cognitive biases cost investors. The "Quantitative Analysis of Investor Behavior" (QAIB) is better known among financial advisers than among retail investors, but ordinary investors would do well to have a peek. (It's not free, but maybe your adviser can give you the lowdown.)

[See Investors: Don't Follow the Herd.]

Indeed, says Dalbar President Lou Harvey, financial advisers are as prone to bias-driven mistakes as their clients. "In fact, you might argue that advisers tend to be more optimistic," he says. "To some extent because they have to sell stuff, but also because their conclusions are reinforced by research and all kinds of information that they're getting that tells them things are certain to get better."

This year's QAIB includes a useful guide to nine common biases that lead people to make bad investment decisions. Below, five of the nine that strike us as particularly consequential. If you're running your own portfolio and you're unhappy with the results, maybe some of these behaviors will sound familiar:

Loss aversion. Dalbar defines this as "expecting to find high returns with low risk." An irrational preference for avoiding losses over achieving gains can lead to destructive investment decisions, such as staying in fixed-income investments long-term for fear of equity-market volatility. A lot of people who've bought bonds recently might learn this lesson the hard way in the next few years if interest rates rise (hurting prices of existing bonds) and equity markets revive, and they miss out on the gains.

Narrow framing. We all make decisions—sometimes impulsively—without taking into account all of the implications. Granted, it's impossible to anticipate every possible ramification to an investment or any other sort of decision. But some things aren't all that hard to consider. You'd be guilty of narrow framing if you'd bought an attractive pharmaceutical stock without considering whether you're already overweight in that sector, or if you'd bought a fund without checking to see if its holdings already overlap substantially with a fund you already own.

[ See 4 Reasons You Stink at Managing Your Own Money.]

Anchoring. The "anchor effect" is at work when we use reference points established by experience. Trouble is, the reference point may no longer be relevant. Example: Stock A was trading at around $100, and now it's at $50. The anchor effect leads you to assume that the price "belongs" at $100 and is bound to revert—therefore you should buy the stock. True, you sometimes find stocks and funds that the market has momentarily oversold (or overbought). But it could be that the stock fell to $50 for a good reason—say, its fundamentals have deteriorated in some way. The fact that it used to be $100 says nothing about where it should be priced now or in the future.

You see a similar phenomenon when people project current conditions indefinitely into the future. That's one of the chief contributors to asset bubbles—the popular belief that since the price of houses, stocks, or tulip bulbs has been rising for the past few years, it will therefore continue to rise. So we buy at the top of a bubble and get burned when it bursts. Likewise, when prices are depressed, we tend to think the market will never come back—so we stay out and miss the rally. There's a reason for the old saying that the most dangerous four words in investing are "this time is different."

Mental accounting. Let's say you get a big tax refund or win big at the weekly poker game. Despite the fact that you're heavily in debt, you see the windfall as "free money" that you can spend frivolously without any impact on your complete financial picture. But money is "fungible," so a dollar you find in the street is no different than a dollar you earn at work.