One of the most interesting areas of finance is called behavioral finance, which is the study of how our behaviors can influence the outcomes of our portfolios.
According to H. Kent Baker and Victor Ricciardi in The European Financial Review, there are several behavioral biases that can impact your investment portfolio and result in lower returns.
Here are two of those biases:
1. Representativeness
According to Baker and Ricciardi, this bias results when you label an investment “good” or “bad” based on recent performance — rather than looking at the fundamentals.
An investment might be considered “good” if its recent performance has been positive. As a result of this bias, an investor might buy something even if it’s overvalued. Representativeness encourages you to buy high. On the other hand, this bias can also cause you to overlook good deals because of a recent poor performance.
As you can see, this bias can lead to you missing out on investments that have solid growth potential, while paying too much for investments that might be at their peak.
Instead of basing investment decisions on recent performance, it’s a better idea to look at investment fundamentals to get a better idea of the true value of an investment. Look at “big picture” items such as management, balance sheet, and potential growth. You can also look at figures like P/E ratio to get an idea of whether or not the investment is overvalued or undervalued. If an asset with solid fundamentals is doing poorly in the short-term, it might actually be a good deal.
2. Familiarity
Another bias that Baker and Ricciardi tackle is familiarity, which is the idea that you prefer investments you recognize. You might choose to invest in a company you’ve heard of over one you don’t really know. Familiarity also manifests as a preference for domestic assets over foreign assets.
As a result, familiarity can lead to a lack of diversification in your portfolio. While it’s true that you should understand the assets you invest in, it’s also true that you need to go beyond a few assets. Familiarity might lead you to invest too heavily in one industry, sector, or geographical location — and you need more diversity than that for a well-balanced portfolio.
The good news is this doesn’t need to be all that risky. If you want to diversify, but are wary of foreign investments, consider using index mutual funds and ETFs. It’s possible to invest in an all-world ETF that provides you with exposure to foreign assets without as much risk or individual stock picking.
While there’s no way to completely eliminate risk from your portfolio, you can invest smarter when you’re aware of your behavioral biases. Examine your investing style for these biases, and then make changes to improve your portfolio.
Do you have either of these behavioral biases? How have you controlled them?
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