How Emotional Biases Can Affect Your Portfolio — And What to Do About It

Chris Wolfe, CFP® and CFA, Chief Investment Officer, First Republic Private Wealth Management
December 19, 2017

Investing is often an emotional activity whether we’re aware of it or not. As humans, we have a tendency to make decisions — such as when to buy and sell particular stocks — based on how we feel rather than what rational thought tells us to do.

And that’s not always a bad thing: You might choose to invest in a certain company because you’re passionate about its goals or corporate practices. Or you might not invest in a company because you don’t support its business model — even if that company is worthy for your portfolio from a strictly financial perspective. It’s important to design an investment portfolio you feel good about overall.

But while emotions can be a compass, they can also result in an undisciplined approach to investing. Discipline means consistency in approach and making rational, sometimes counterintuitive, decisions when you are in a position of relative strength to make those decisions. Fear and greed, which are intertwined with a range of other emotions, are the enemies of disciplined investing.

Let’s take the example of someone whose portfolio has grown significantly in recent years thanks to the strong bull market. That portfolio — assuming it was never rebalanced — probably has a much larger exposure to stocks than what the investor should have based on their risk tolerance and financial goals. In this situation a disciplined investor will rebalance while they are in a position of relative strength — while that decision is still an option for them. However, most investors would find the decision to rebalance very difficult when markets are running high. Many investors even say they are fearful, but still remain overexposed to stocks.

The desire to keep generating strong returns (fueled by greed and exuberance) leads the investor to take on more risk than what is necessary to reach their goals. This puts them in a position of weakness when markets eventually correct and they are then forced to take additional risk in order to reach their original goals, or worse, they are forced to dial back those goals. 

Understanding the biases of investing

Our emotions ultimately create biases that can be detrimental to our investing and lead us to make decisions that aren’t in our best interest. Here are a few common investor biases to be mindful of when making investment decisions:

Recency bias

The belief that whatever happened in the recent past is going to happen in the future. This is the bias of an investor who thinks the market’s strong performance in recent years is bound to continue. As we know, past performance is no indication of future results.

Loss aversion

The preference of avoiding losses to acquiring equivalent gains. Financial losses are felt more acutely than corresponding gains, which results in investors taking less risk than necessary to achieve investment goals or taking no risk at all. In other words, take the appropriate risks based on risk tolerance and time horizon.

Anchoring

Over-relying on initial information to create a psychological benchmark or "rule of thumb" that drives investment decision-making, even when that initial information is irrelevant. This phenomenon is seen most acutely when investors hold declining securities because they are anchoring to the price they originally paid for it, which may no longer reflect current fundamentals.

Becoming a more disciplined investor

No one is impervious to bias but it is important to understand how emotions and biases might be guiding your investment decisions and determine whether they are ultimately affecting your performance. Biases can prevent you from making rational decisions that could improve your portfolio's long-term performance. They can also lead you to have a cluttered portfolio that doesn't reflect your goals, may be too risky or not risky enough. 

Thankfully, it’s not difficult to become a more disciplined, less emotionally driven investor. Here are four steps to think about:

1. Set a target.

Have a goal for your portfolio’s future value, whether over five years or 20 years. This helps you think more logistically about how you invest. Each year you can see how close you’re getting to your goal and determine whether it makes sense to change your asset allocation strategy in order to reach that goal.

2. Take small steps.

If you’re doing something dramatic — like pulling all your money out of stocks or holding a big piece of your portfolio in one stock — you’re probably letting your emotions get the best of you. Resolving to take small steps and being patient can prevent you from making rash decisions.

3. Identify goals and priorities.

What are your ultimate goals for your money? Will you be funding your children’s or grandchildren’s college education or traveling the world? Not knowing yourself and your financial priorities is often the root of emotional investing. Once you know your priorities, you can build a plan that keeps you rooted in reality and prevents you from veering off course.

4. Work with an advisor.

A financial advisor can help you think more rationally about your investing — guiding you on smart practices (such as developing an asset allocation tailored to your needs) while also helping you establish realistic goals. Humans have emotions — it's natural. But when it comes to investing, you need to understand whether your emotions are helping or hurting your choices.

A financial advisor can help you design a portfolio around your long-term goals and priorities and prevent your emotions and biases from leading you astray.

Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.

©2017 First Republic Investment Management