Behaving Badly in Las Vegas

There is arguably no better place in the world to observe bad behavior than on the Las Vegas Strip. After all, “What happens in Vegas, stays in Vegas.” However, when it comes to behaving badly, we investors can give Vegas casino-goers a run for their money.

At the 2019 AICPA ENGAGE wealth management conference in Las Vegas, I attended a session entitled, “Behavioral Aspects of Portfolio Construction.” The presentation covered several behavioral biases that cause investors to “misbehave” and was a helpful reminder of the behaviors we see come alive every day. Five are worth noting:

1. Loss aversion: Nobody likes losses in their portfolio. In fact, investors feel losses 2-3 times as much as gains. The pain of the fourth quarter of 2018, when stocks fell by double digits, far exceeded the joy felt as the market recouped those losses during the first quarter of 2019. Loss aversion also causes us to never want to admit defeat, making us hold securities too long to avoid realizing a loss, sell profitable positions too soon, and avoid riskier assets. To combat this, understand your risk tolerance. If you are strongly averse to negative outcomes, you need to take less risk.
2. Anchoring: We use reference points (anchors) to make decisions. We hold onto Amazon stock purchased for $2,000/share even when it drops to $1,500/share because we want to wait until it reaches that $2,000/share price again even though the only rationale for that price is “because that’s what I paid for it.” Or we may benchmark a globally diversified stock portfolio to the S&P 500 because it is an easy reference point, even if the S&P 500 only holds 500 large companies in the U.S. It’s important to set aside those artificial anchors and look at things through a more appropriate lens.
3. Familiarity: We invest in what we know best. However, by doing so, we may miss out on attractive investment opportunities or hold too much of an investment. For instance, most investors are familiar with Apple, Amazon, and Google. These stocks are popular and have performed well recently. Because of that, we overpay to own these stocks which negatively affects future returns. Less familiar value and small-cap stocks are often overlooked and have performed materially better over time.
4. Overconfidence: Humans are overconfident. It serves us well as a species. However, when it comes to investing, overconfidence works to our disadvantage. Overconfidence leads us to think we can time the markets. Overconfidence causes us to be irrationally exuberant when times are good and overly fearful when times are bad. That’s why markets overshoot – positively and negatively. The fourth quarter of 2018 was the worst quarter in decades even though nothing had drastically changed economically. Markets oversold and then bounced right back. If you had sold out of stocks right before December 26, 2018, would you have had the confidence to get back in?
5. Recency: We look at recent trends and expect they will continue. Just because Lebron James hit the last 10 free throws in a row doesn’t mean he’s more likely to hit the next one. U.S. stocks have done fabulously the last few years. Recency bias tells us that’s likely to continue going forward. We forget that there are many periods of time when the U.S. doesn’t win. It’s typically better to bet against the trend. Rebalancing your portfolio is so important. Having a disciplined investment strategy removes emotion and focuses on the long-term rather than recent trends.

When it comes to your portfolio, keep these biases in mind. You will be a savvier investor – and a better behaved one.