6 biases of fund investing
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Christine St Anne: Behavioral biases in investing, happens when investors allow their emotions to dictate their decision making. To give us an insight into what these biases are, I'm joined by Morningstarï¿½s Darren Cunneen.
Darren Cunneen: Thank you, Christine.
St Anne: Darren, one of the behavioral biases is known as loss aversion. Can you give us an insight into that type of behavior?
Cunneen: Well, Christine, loss aversion is simply an unwillingness for investors to accept or recognize losses. Now, whether this is investors holding on to a struggling fund or for poorly performing stock, they aim to either recoup their losses or at the very least breakeven.
Now, unfortunately by doing so, they take on additional risk. This contradicts traditional finance theory whereby investors take on additional risk with the hope of getting additional rewards, whereas with loss aversion investors take on additional risk with little expected rewards.
St Anne: So should investors sell their funds on performance alone?
Cunneen: Of course not, Christine. We would never recommend to our investors to sell a fund based on performance alone, especially in the short term. We do, however, recommend for investors to revisit a fund's fundamentals to identify if there have been any material changes.
For example, within Morningstarï¿½s Fund Research, we assess the fund based on the five key pillars of analyst research: that's people, parent, price, process and performance. Importantly, if there have been any material changes to any of these, then it may be time to look elsewhere.
St Anne: Darren, what about anchoring bias? Can you give us an understanding about that type of behavior?
Cunneen: Anchoring bias is basically a tendency for investors to fixate on a particular data point or target number. Now, this could be a particular stock price, it could be an index level, it could be one of the many number of data points.
For example, the S&P/ASX200 reached an all-time high of 6,800 in 2007. Investors believing that this will revert in due course and become fixated or anchored to this particular data point and may consequently overexpose themselves to Australian equities.
St Anne: Home bias is also another common behavioral trade. Can you explain a little bit about that and how can investors overcome that kind of bias?
Cunneen: Home bias is a tendency for investors to over-allocate to domestic assets. The problem here is that this leads to an inherent riskiness and a lack of diversification. We recommend establishing a global allocation and implementing accordingly. For investors fairing the unknown global markets, a passive strategy maybe the way to go. By doing so, investors remove the need to make active decisions, such as country or style specifications for particular fund managers.
St Anne: Darren, you also mentioned a form of passive investing as a behavioral bias. Can you give us an insight into that kind of bias?
Cunneen: Sure, Christine. I believe youï¿½re referring to ï¿½status quoï¿½ bias. This is a tendency for investors to take an inactive approach to investing. It's almost a ï¿½do-nothingï¿½ approach. The problem here is that asset allocations can stray without intervention, leading to sub-optimal asset allocations. The risk characteristics of a portfolio can also change markedly. This can be of particular importance for, letï¿½s say, superannulation portfolios, whereby investors should be shifting towards capital preserving and less risky assets as they age.
St Anne: Herding is also another key issue for investors. Darren, can you give us an insight into that sort of behavior and perhaps some examples?
Cunneen: Of course, well, herding is basically a tendency for investors to avoid the mental anguish of going against the crowd. As you know, people value the comfort of solidarity; they simply just don't want to be different.
So we've seen this multiple times throughout history. For example, the late ï¿½90s dotcom bubble, and probably more recently, the Facebook IPO, and I guess, arguably the mass exodus out of risky assets in to more defensive assets such as term deposits can also be considered another form of herding.
But overconfidence in your fund can be a positive; however, overconfidence if left unchecked can lead to an overestimation of the upside and an underestimation of risk. Overconfidence effect can be two-fold. First, investors can be overly assured of their ability to identify best-of-breed funds, and a good remedy for this is for investors to seek an opposing view or a second opinion. This is where the Morning Analysis Report can come in handy.
Secondly, investors can become over-reliant on a particular fund. To mitigate this, we recommend for investors to pay close attention to the role in the Portfolio section of the Morningstar research reports. Primary asset-class exposures should be achieved through what we call ï¿½core portfoliosï¿½. These are well-diversified and liquid portfolios, whereas additional returns can be achieved through satellite and supporting players, which can add additional returns but should be used in smaller allocation.
St Anne: Darren, thank so much for your insights today.
Cunneen: Thank you, Christine.
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