The S&P 500 returned 8.21% in the 20 years ending in 2012. Naturally, you might expect the average investor’s return to be somewhere in that neighborhood. The reality is that the average investor has experienced significantly lower investment returns at 4.25% — almost a full 4% lower than those generated by the passive S&P 500 portfolio.
Why can’t the intelligent human mind with its flexibility and an arsenal of investing tools beat the unmanaged index? The reason is quite simple: we are irrational beings.
The Irrational Human: A Survey of Biases
We make decisions based on fear or greed rather than sound reason and logic. Psychologists and behavioral economists have catalogued the cognitive and emotional tendencies that mess up our ability to make rational, unbiased decisions. Here is a summary of the most prominent biases:
- Availability bias: An investor makes decisions based upon the information that is readily available and his/her awareness of it.
- Representative bias: An investor makes decisions based upon history and stereotypes.
- Confirmation bias: An investor who has already decided upon a course of action will look for evidence to support his/her decision while ignoring anything to the contrary.
- Anchoring: After being presented with a reference point, an investor overweights that reference point relative to new information in making decisions.
- Overconfidence: An investor will believe his/her decision will always be a good one.
- House Money effect: An investor will treat money gained through investing profits as “free money” and tend to make riskier decisions with that money.
- Myopia: An investor will check results often and take action based on short term performance.
- Loss aversion: An investor’s pain of loss is greater than the joy from gain.
- Pride and regret: An investor has a need to feel proud of making a profitable investment and not experience the regret of having made a poor investment decision.
- Endowment effect: An investor places a higher value on what he/she owns over what the market does.
- Snake Bite Effect: An investor who has had a negative experience, when presented with a similar situation will avoid that strategy whether or not it reflects his/her needs and goals.
All of these biases have been very well studied by several behavioral economists in relation to investing. The conclusion? These psychological barriers cost investors quite a bit of money. What is not as well studied, but perhaps even more interesting, is the question of gender differences when it comes to investing biases. To be precise:
- Do men and women both have the same biases?
- Are there behavioral differences between men and women when it comes to investing?
There is substantial literature for Question #2, which concludes that – Women are better investors than men. Question #1 though, is not often directly studied (which prompted us to take our own look in the article, Real Data Suggest Gender Biases in Investing).
In this post, I seek to delve further into the behavioral patterns of men and women to see if they suggest different investing biases. To begin, let us start with analyzing the evidence supporting the claim that women are better investors than men. Is there any inherent advantage to being a woman?
What Makes a Woman a Better Investor?
- Women are more risk averse: As was found in the Personal Capital gender study, women in general are more risk averse than men. This finding is supported by a growing body of research. Starting from wearing seat belts to choosing investments in their portfolio, women tend to favor safer options even with lower returns than riskier options with potential high returns.
- Women do their homework: Male investors, in general, are overconfident; women on the other hand are skeptical investors. Women are also more willing to acknowledge when they don’t know something. That leads to them doing more homework before investing.
- Women trade less: The same study that focused on overconfidence in men also documented that as a result of that overconfidence men tend to trade more than women. In fact, men trade 45 percent more than women and that reduces their net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women.
- Women take more time to make investment decisions: A 2012 InvestmentNews survey of 323 financial advisors found that women tend to take more time to evaluate investment choices and make decisions. They also focus on long term strategies rather than short term gains.
- Women are more pessimistic about the probability of high likelihood gains when compared to men. So in general they stay away from “hot” stocks.
On the Other Hand, What Might Make a Man a Better Investor?
If women in general are better investors than men, then all we have to do is give women full rein over the portfolio right? Not so fast. The above mentioned qualities are great ones, but they are not without fault.
- Risk aversion is not always the right approach: According to the 2012 Vanguard Equity Investor Study, in portfolio selection women have a preference for fixed income holdings versus equity. This is not always the right move. For example, when saving for retirement or any long term goal, a very safe portfolio is not going to return much, especially after accounting for inflation. This point also demonstrated in our post on gender biases– female Personal Capital users have a lower risk tolerance than male Personal Capital users by 7%. This tendency, over a long time horizon, can translate into a 10%+ reduction in portfolio values over long time horizons.
In addition to sacrificing the value of the portfolio in the long run, the risk averse nature of women also makes them more concerned when the volatility of the financial market increases which might lead to loss aversion.
- Women prefer to network to gain knowledge: Researchers Tahira Hira and Cazilia Loibl from Ohio State University found that women rely on personal networks – friends, family and workplace to gather information whereas men tend to enjoy learning on their own. While both approaches have its own merits and shortfalls, relying too much on personal network for knowledge might lead to availability and representative bias.
Source: Women & Investing, Gender differences in investment behavior. FINRA Report August 2006
In essence it looks like men might be more susceptible to the following biases:
- House money effect, and
- Confirmation bias
On the other hand, women are more susceptible to the following biases:
- Loss aversion
- Availability bias
- Representative bias, and
- Snake bite effect.
Like other gender differences, these rules are not universal. Additionally there are studies that cite that other social factors such as age, marital status, education and economic status plays a more influential role in investment decisions over gender.
Forging a Road Ahead
If all of us, irrespective of gender, race, age and any other social factors are vulnerable to making bad investment decisions due to our psychological biases, are we doomed to always have sub-par returns? Not if we understand who we are as an investor and focus on ways to successfully work towards our goals.
- Understand and embrace your irrationality: It is in our best interest to not deny or run away from our emotions, we should accept our irrationality and incorporate those in our decision making to ensure it is in line with our goals.
- Identify your personal influence of biases: This can be tricky. We have to first understand the biases and how they are triggered; then we need to formulate questions that will identify whether we are influenced by a certain bias. For example, ask yourself this question – “If you toss a coin five times and each time it lands on a head, what is the most likely outcome of the next toss?” If you answered head or tail, then you have representative bias. The answer should be “neither”; past performance is not an indication of future performance. Books and research by behavioral economists Dan Ariely, Jason Zweig and Daniel Kahneman have some sample questions to start with.
- If you are in a relationship, understand each other’s strength and use it to your advantage: As demonstrated above, each of us is unique and have our own strengths and weakness. So develop a holistic approach to your portfolio – discuss your goals, time horizon, risk tolerance, liquidity needs and personality with your partner and come up with a strategy that will work with both of your needs.
- Systematically monitor your progress: Schedule a periodic review of your portfolio. Focusing on the big picture and ignoring short term return, see if it is still in line with your goals.
- Don’t be afraid to get help. There are resources available to make sure you’re on the right track. If you’re a do-it-yourself investor, you can use a tool such as Personal Capital’s Investment Checkup to see how your portfolio compares to a target portfolio that fits your financial profile. And ultimately, it’s helpful to have a second set of human eyes on your portfolio – whether it’s a knowledgeable family member or a financial advisor – to make sure you’re on track.
When it comes to investing, it is extremely important to understand ourselves as an investor; our goals, personality, mindset and emotional needs. Knowing what your strengths and your weakness are, will help you make better investment decisions.
Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing – Warren Buffett