My father had one bad financial habit that he never got over.
Over the years, he built a diversified investment portfolio that covered virtually all corners of the investment spectrum, except for one.
He could never buy a small-cap mutual fund or invest in small or micro-cap stocks. Oh, he tried a few times, but as soon as performance went through a rough patch and he looked into a portfolio and saw a bunch of names he didn’t recognize, he lost confidence and bailed out.
His problem, in investment terms, is called “familiarity bias,” the preference to invest in things or in places you know, and it’s one of the top five biases that financial advisers see as significantly affecting individual investor behavior, according to the BeFi Barometer 2019 survey released this week by Charles Schwab Investment Management.
BeFi stands for “behavioral finance,” and the idea behind the study was that identifying our own misgivings could help us avoid making common mistakes and could foster the emotional discipline necessary to have and stick with a financial plan.
It’s particularly important now, says Omar Aguilar, chief investment officer of equities and multi-asset strategies at Charles Schwab Investment Management, because the stock market is heading into a period where most experts expect lower returns and higher volatility, two conditions that trigger the psychological and emotional biases that most investors have at heart.
Advisers in the survey worried that individuals — left to their own devices and at the whim of their own biased minds — would be easily influenced by current events, and that the moves they make in response would short-circuit long-term investment strategies.
It’s the underlying cause of the classic investment behavior where investments perform well, but individuals can’t stomach the ride.
As a result, they buy into things that look good because they have recently gone up in price, and then dump those investments at the first signs of trouble, creating a cycle of buying high and selling low that is the opposite of their intentions.
“We are all subject to these biases,” Aguilar said during an interview on “Money Life with Chuck Jaffe,” my radio show/podcast. “There is nothing wrong with that, it’s just who we are. … It is impossible to get rid of these biases, but [people can] mitigate some of the most common biases that drive investors to the wrong decisions.”
The five most common biases cited by the advisers in the BeFi study were:
Recency bias: Someone is swayed by recent news or experiences, buying what’s hot and selling on headline news.
Loss-aversion bias: Investors play it too safely or accept less risk than they can tolerate, thereby falling short of their savings goals.
Confirmation bias: Investors seek information that reinforces their thinking, and then act as if their hunches are sure-things.
Anchoring bias: The individual focuses on a specific reference point — like the break-even point — in making investment decisions, rather than making the best possible moves now.
Familiarity bias: My dad’s issue, needing to see names he was comfortable with, also applies to investors who might want to invest only in a market they know, like the United States, or in specific asset classes.
None of these biases are debilitating, so long as they are accommodated and planned for.
Every time my dad went through a portfolio evaluation, experts would point out that he lacked small-cap exposure.
The lack of small-caps meant he was ignoring a part of the market that traditionally promises big returns, and that often moves in different cycles than brand-name big companies.
Yet every time my father tried to invest in small-cap stocks, he wound up being disappointed and bailing out. He had good funds, but he exhibited classic buy-high/sell-low behavior.
So he stopped trying to invest in small caps and told the advisers he would be a better investor with the level of diversification he was comfortable with. He asked his advisers to come up with a work-around.
The Schwab study is all about advisers and the biases they don’t want to see in clients, but the job of those advisers isn’t to force individuals to buy things they’re not comfortable with, but rather to help them confront their biases to decide upfront what they can live with and what freaks them out.
From there, the job is to build a portfolio that will foster the emotional discipline necessary to stick with a plan.
The more you understand about yourself — the more you can build a portfolio that you can follow without falling victim to your behavioral frailties.