Key Points

  • Overconfidence and loss aversion can both lead to poor investment performance.
  • Overconfident investors tend to hold overly concentrated investment portfolios, which can increase idiosyncratic risk, and overall risk of loss.
  • Loss aversion can lead to under-participation in the markets, such as by going to cash when the markets begin to falter. This too can degrade investment returns over time.

Recap

So far we have introduced a handful of behavioral biases that humans tend to fall victim to from time to time. But let’s now take a closer look how two of these biases, namely Overconfidence Bias and Loss Aversion Bias can impact your investment portfolio returns.

Again, Overconfidence Bias is the tendency of humans to overestimate their skill or chances of success. The notion that most of us think we are better than the average driver is a great example of this phenomenon.

And as discussed, Loss Aversion is the notion that humans tend to be more concerned with the magnitude of a loss than an equally comparable gain. Research suggests that we would prefer to win more than 200% more than we stand to lose when taking on risk (based upon the work of Amos Tversky and Daniel Kahneman).

When it comes to making investment decisions, these types of biases can impact performance and returns, but let’s see how this actually plays out by exploring some academic research on this topic.

The Bottom Line

At the end of the day, long-term financial success can come down to three simple points: how much can you save? how much in returns can you generate? and how much risk do you end up taking?

The ultimate goal is to therefore safe plenty, return handsomely, and control risk sensibly. However, behavioral biases can interfere with this objective every step of the way, so it’s in your best interest to control behavioral biases whenever possible.

“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ…Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing” (Ro, 2014; Stone, 1999). —Warren Buffett

When it comes to investing, overconfident investors tend to make too many large bets on too few positions (and thus increasing idiosyncratic risk), while loss averse investors tend to go to cash when the markets get shaky (and thus missing out on upside opportunity).

Why Investment Mistakes Persist

Shan Lei and Rui Yao discuss these very notions in their 2015 research paper, Factors Related to Making Investment Mistakes in a Down Market. Shan Lei is an assistant professor with the Department of Accounting, Economics & Finance at West Texas A&M University; while Rui Yao, is an associate professor of personal financial planning in the MU College of Human Environmental Sciences.

One common mistake among investors is to not adequately diversify investments. This means that many investors tend to invest in just a few securities, which leaves them open to idiosyncratic risk (i.e., the risk that a given security may experience a one-off negative event, such as the CEO passing away, or its company being investigated for fraud). The best way to overcome this risk is to diversify, but overconfidence leads investors to put too much faith in to few positions.

Another common mistake is to sell off positions during a down market. The prevailing belief is that by going to cash, one can sidestep market turmoil, and then ultimately re-enter the market once the market calms down again. This strategy underpins the core notion behind Market Timing, and as we discussed in that series on this topic, following such a notion can lead to significant losses over time.

Market timing is the strategy of making buying or selling decisions of financial assets (often stocks) by attempting to predict future market price movements. —Wikipedia

But now, let’s dig into the psychology of these common behaviors to better understand what actually drives individuals to pursue these types of non-optimal investment strategies to begin with.

The Research

According to the paper by Lei and Yao, overconfidence leads investors to believe they are better than the average investor. For example, also according to the paper, “Montier (2006) found that 74% of the sample fund managers believed that their performance was above average.” As discussed, overconfidence leads to under-diversification (e.g., stock picking leads to an increase in unsystematic risk). The notion that by outsmarting the market an individual can pick stocks that the market has not priced correctly is a key factor of active management strategies. But clearly, 74% of managers cannot be better than the average. Only 50% of managers can mathematically hold this title, and based upon our past research on this topic, it’s quite likely that this 50% is lucky at best.

In addition, “Loss-averse investors are then likely to sell in down markets.” For example, loss aversion often leads to under-participation (e.g, going to cash when things get shaky). As we’ve also discussed in the past, by selling at the wrong time, an investor can miss out on significant upside potential. The opportunity cost of not being invested can weigh on future returns such that it’s almost impossible to catch up if one misses just one good year of market returns. As such, both of these effects combine to reduce investment returns over time.

According to the paper by Lei and Yao, “Calvet et al. (2006) measured under-diversification by comparing the Sharpe Ratio of a household portfolio to the ratio’s benchmark index. They chose a currency-hedged world index as the benchmark in their research. Under-diversification leads to higher investment risks, which means an increased probability of financial losses.”

The paper further mentions, “Loss-averse investors are more likely to make investment mistakes in a down market. Non-participation in risky assets is an investment mistake that leads to lower portfolio risks and lower portfolio returns. Most investors do not realize that non-participation gives up not only the downside investment risks but also the upside investment gains. Therefore, this leads to opportunity costs that hinder investors’ wealth accumulation (Calvet et al., 2006; Calvet, Campbell, & Sodini, 2009)”

The Results

The study investigated 2,792 self-reported appraisals of investment action during the Great Financial Crisis (2008). “This study used data from the 2008 FPA-Ameriprise Financial Value of Financial Planning Research Study. The data were collected online by an independent market research firm between June 27, 2008 and July 18, 2008.”

The study considered those respondents that moved to cash (even though they didn’t actually need the cash for consumption) to have made an investment mistake given that the move was likely emotionally driven rather than out of financial necessity. In general, this type of market timing tends to diminish returns, as supported by the research of Calvet (mentioned above).

The results showed two themes. First, “respondents who were more loss averse were also more likely to make investment mistakes.” Further, the “results showed that respondents who were overconfident were more likely to make investment mistakes. Compared with respondents who had the same level of confidence at present versus five years ago, those who expressed more confidence were 1.4 times as likely to make investment mistakes.” Essentially, according to the results of the study, those individuals that showed traits of loss-aversion or overconfidence were about 40% more likely to have made a mistake during the Great Financial Crisis in terms of selling out and going to cash.

And as we’ve noted, this type of mistake can be costly. So it behooves any investor to take a hard look at their current strategy and consider whether these two biases might have the potential to impact their returns in a manner suggested by the research above.

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