Last year was a very clear example of how investors can be blinded by biases. 2014 was unique in that most major equity markets performed well below average except for the U.S. large cap market (as measured by the S&P 500). The S&P 500 was up 13% last year while international markets were negative and very little else returned more than about 4%. Many investors immediately became nervous over their portfolios. Some even mulled over the idea of completely getting out of anything outside the U.S. There were a lot of strong reactions to just a single year of performance.
Every year out of all the major assets classes there is going to be a top performer and a bottom performer. It is rare that anyone ever questions why they did not own only the top performer. No one knows which asset class will be the best performer on any given year, and it is universally agreed that diversification can help reduce risk and increase long term return. So why did last year seem to get some investors so riled up?
The importance of investor behavior is being better understood every year. Research consistently shows that for more investors investing success depends more on their ability to avoid common behavioral and cognitive biases and less on their investing expertise. The most popular of these studies is the DALBAR Quantitative Analysis of Investor Behavior.
There are many cognitive and emotional biases that can lead people to make poor investor decisions. Two prevalent biases from last year (among many) were Availability Bias and Framing Bias.
Availability Bias – It is undoubtable that U.S. investors are bombarded with information daily on the U.S. stock market and economy. There are 24-hour business news channels at everyone’s finger tips. This makes them highly susceptible to availability biases. The easy availability of information on the S&P 500 doing well makes it seem more likely this will continue and even feels less risky to investors because the United States is familiar to us. In contrast, we rarely hear about international markets unless it is something negative. So the information the average person receives on a daily basis is highly skewed to favor domestic investing even though the data typically suggests otherwise.
Framing Bias- Framing bias occurs when a person answers a question differently depending on the way in which it is asked. Case in point: “Based on 2014 returns how should I invest?” This is the question a lot of people asked themselves at the end of last year. It however is a very poorly framed question if the goal is to maximize long term return. The time period for investing is much longer than 1 year. We also know that 1, 3 or even 5 year returns have very little predictive power over 10 or 15 year returns. Focusing on a short time frame often leads to very poor investment decisions. In less than 4 months this year the market has closed much of the gap between the S&P 500 and other asset classes from 2014. Below is a performance chart of select asset classes that performed poorly in 2014 vs. the S&P 500 so far this year:
4 months is clearly not enough time to make a conclusion, but neither is one year. Investing takes time and discipline. All investors, including professionals, will be susceptible to different biases. The best thing anyone can do is be aware of what they are and take actions to reduce their effect on our decision making. As Warren Buffett famously said, “Investing is simple, but not easy.”
Stay disciplined and make decisions based on long term empirical evidence. Creating a plan and sticking with it will help all investors avoid the common pitfalls we all fall victim to from time to time.