Minimize Irrational Investing Behavior

Physician's Money Digest, December15 2004, Volume 11, Issue 23

As a physician-investor, the oddsare you are your own worstenemy. In recent years, an increasingnumber of researchers, particularlyin the field of psychology, have cometo believe that investors undermine theirinvestment and financial goals throughsuch emotionally biased and irrationalbehaviors as overconfidence, herd mentality,bias toward recent market results, andan excessive aversion to risk.

Eliminating such biases is difficult, butinvestors can mitigate their impact byfollowing several time-tested investingand financial planning principles.

Invest for the Long Term

Investing in riskier assets, such asstocks or real estate, should always bedone for long-term goals: retirement,college, and end-of-life gifts to heirs orcharities. A rough rule of thumb mightbe that you shouldn't need that investmentmoney any sooner than 5 years,and preferably 10 years or longer.

Investing for the long term can helpthwart two common investing behavioralmistakes: recency bias and herdmentality. Recency bias occurs becauseinvestors tend to focus on recent marketpatterns, whether positive or negative,and project those patterns into thefuture. By focusing on long-term goals,investors are less apt to be caught up incurrent market events.

Remember to Diversify

Another striking behavioral habit ofinvestors is their overconfidence andexcessive optimism. Princeton Universityprofessor Daniel Kahneman, who won a2002 Nobel Prize for his studies of behavioralfinance, points to studies that askedinvestors to estimate how high and howlow they thought the stock marketmight be at certain points in thefuture—estimates so high the investorswere 99% certain their estimates won'tbe exceeded. Yet even then, their estimateswere exceeded 20% of the time.

Overconfidence about investing skillsalso tends to lead to excessive trading. Astudy by two California professors of60,000 households that traded stocksfrom 1991 to 1996 found that the averagehousehold underperformed themarket by 3.7% each year, but thosehouseholds that traded the most underperformedby over 6%. A follow-upstudy found that men traded 45% morethan women and suffered lower risk-adjustedreturns.

A well-diversified portfolio, developedfrom a well-crafted investment allocationpolicy that fits your long-term investinggoals, can help minimize excessive trading,overconfidence, and market surprises.

Look at the Big Picture

Investors tend to obsess over individual,short-term losses and gains, especially losses.The prospect of a loss so greatly outweighsthe prospect of a gain of similarmagnitude, researchers say, that investorsbecome too conservative, thus underminingtheir long-term investment goals.

One study, for example, found thatinvestors tend to sell off investment winnersfar more frequently than losersbecause they hate to realize losses, especiallylarge ones. Yet the study foundthat the winners they sold generallywent on to outperform the losers theykept by 3.5% the following year.

Wise investors, on the other hand,worry little about individual gains andlosses in their portfolio. That's becauseresearch has shown that even thoughspecific investments or specific investmentcategories will suffer losses at anygiven time in a properly diversified portfolio,the overall portfolio performancewill be positive over time, with much lessrisk than if the investor tries to avoidlosses by putting everything into the currenthot investment.

This article has been produced by the Financial

Planning Association (www.fpanet.org), which is

the membership organization for the financial

planning community.