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Co-authored with guest blogger, Nelli Oster

Many finance experts assume that investors act rationally to maximize profits while minimizing risks.

But as we write in our new Market Perspectives paper, investors routinely make a number of irrational missteps that can be explained by a growing body of behavioral finance research, which studies how people make money-related decisions. Here’s a look at three of these common investing bad behaviors.

1.) Stock Market Avoidance. Many people avoid risky assets like the stock market despite the high cost of staying out of such investments, particularly in the current, low-yield environment. Consider, for example, that adjusted for inflation, the return on cash left in a bank account was negative for 2012. In comparison, world equity markets as measured by the MSCI All Country World Index returned 13.4% in U.S. dollar terms during the same period.

Why do some investors shy away from stocks? Behavioral finance studies have found that investors are roughly twice as sensitive to losses as they are to gains. In addition, people tend to evaluate gains and losses over a relatively short time horizon that may not be in sync with the longer horizon over which investment goals are expected to be achieved. This extreme fear of losses in the near term, combined with people’s tendency to look at each investment in isolation, helps to explain low stock market participation rates.

2.) Insufficient Diversification. Another common investor mistake is to have an under-diversified portfolio. In a 1991 to 1996 study of the customers of a large US discount brokerage, more than 25% held only one stock, and more than 50% held three or fewer stocks. However, a well-diversified portfolio should include at least 10 to 15 stocks, which only 5% to 10% of the investors held in any given period. And generally speaking, the more diversified portfolios performed better: the most diversified investor group in the study earned more than 2% a year higher returns than the least diversified group[1].

Behavioral finance concepts behind this mistake include investors’ tendency to use certain rules of thumb (for example, dividing assets evenly into funds) for allocation decisions, and to opt for familiar home-market stock names that can be recalled easily.

3.) Inefficient Trading. Many investors tend to move in and out of positions in an inefficient way, reducing their potential profits. This may be because individual investors are often overly confident in their own abilities to beat the market, and thus trade excessively and hurt their portfolio performance. (Dan Morillo recently talked about overconfidence and investing in his blog post on failed New Year’s resolutions.)

Investors also often make the cognitive mistake of extrapolating from past returns, buying assets whose prices have gone up in the expectation that prices will continue to increase. At the same time, people tend to be more likely to get rid of stocks that have done well in the past, and to keep the losers so as to avoid the mental pain associated with realizing losses. In behavioral finance, this latter concept is known as “the disposition effect,” and it’s particularly striking considering that based on tax considerations, people would be expected to sell losers to exploit capital losses and defer taxable gains.

The good news is that you can take certain steps to possibly help mitigate the impact of these common mistakes. These include:

  • To feel more comfortable about investing in risky assets, consider focusing on how one’s overall wealth is doing rather than focusing on each asset in isolation. This can help give each asset credit for its portfolio diversification benefits. In addition, consider viewing investments from a longer time horizon, which can help smooth out fluctuations in stock market performance.
  • Consider increasing portfolio diversification by investing in well-diversified index funds or exchange traded funds.
  • Consider rebalancing a portfolio periodically with a rules-based or systematic investment approach to help lessen investor biases.

Source: “Breaking Bad Behaviors: Understanding Investing Biases and How to Overcome Them”, iShares February 2013 Market Perspectives

[1] Goetzmann, W. N. and Kumar, A. (2008) “Equity Portfolio Diversification,” Review of Finance, Vol. 12, No. 3, 433-463.

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Source: Overcoming 3 Bad Investing Behaviors