Behavioural biases in asset allocation
25 October 2016
Investor behaviour often deviates from logic and reason, with emotion and individual personality traits biasing investment decisions. Even after working with an adviser on an investment policy statement based on risk tolerance and other objectives, investors often have trouble shedding beliefs and behaviours that may hurt their returns. Below we look at some biases that investors may be prone to in relation to asset allocation:
Representativeness (or recency bias). This is where investors label a fund or security as good or bad based on its recent and often short-term performance. They will therefore ‘chase performance’ and buy ‘hot’ sectors, funds or stocks, those that have risen a lot in price recently, expecting them to increase yet further, regardless of their intrinsic value. Similarly, they will sell or ignore those that have fallen heavily in the recent past, even though the investment may now represent good value and selling it would result in the investor crystalising losses. Also, many studies have shown that fund outperformance fails to persist - ‘past performance is no guide to the future’ as the well-known disclaimer says. Firms, though, will take advantage of this bias and increase advertising of those funds that have experienced good performance!
Related to the above is herd mentality - investors that buy when the market is high and sell when it is low are often influenced by herd mentality. People can feel better when investing with the crowd and don’t want to be left out of the latest trend, even if it is not in their best interests. Just because ‘the herd’ is moving into a region, asset class or fund, this doesn’t mean an investor with their own individual objectives should.
Familiarity bias is investors associating familiarity with low risk. Home country bias is the best example of this, where investors hold a significantly higher proportion of domestic securities, usually equities, in their portfolios than world market capitalisation weights would suggest, even though the benefits of international diversification across a portfolio are well known. Another example is people holding high amounts of shares in the company they work for. The implication of both of these examples is that the portfolios will almost certainly be sub-optimal.
Finally, anchoring, which is where a subjective reference point is used to make future decisions. For example many investors still anchor on the 2007/8 financial crisis. As a result, they may hold less equities in their portfolios than they should because they are now excessively risk-averse. Another example is the disproportionate interest in round numbers in market indices - such as selling UK equities when the FTSE 100 Index passes 7,000 or buying when it falls below 5,000 - even those are just numbers like any other.
There are many different behavioural biases in investment and we have looked at just a few here. The main way to avoid these and other such biases is to become aware of them. Then investors have a much better chance of avoiding them, or at least reducing their effects and making more impartial decisions based on the available data and logical processes and rules.