One critical solution to overcoming flawed investor behavior is having a proven, repeatable process that guides decision-making. Discipline keeps your clients’ emotions in check and their perceptions clear.

This article first published in March 2019, and I believe the message still applies today.

As a retired money manager, I want to share some thoughts on that profession and investors in general.

Portfolio management is as much about managing emotions as it is about correlations, standard deviations, and Sharpe ratios. Over the decades, much has been written about the “math” of portfolio management, but the emotional aspect of the investment decision-making process has not received nearly the same attention or research. However, behavioral finance is a relatively new field. It seeks to combine behavioral and cognitive psychology theory with conventional economics and finance to explain why and how people make investment decisions.

A great deal of research demonstrates that investors consistently underperform the S&P 500. The most frequently cited research comes from Dalbar Inc., which shows that investors have underperformed the Index by more than six percentage points per year over the past 30 years.

Source: Dalbar Inc.

Even with some of the brightest, best-educated, and most well-intentioned professionals, about 70% of money managers also underperform their benchmarks. Is something in our brains impairing our ability to make rational investment decisions? The same abilities that have made us smart in many areas also make us less so when it comes to investing.

Behavioral finance has uncovered a surprising number of subconscious idiosyncrasies that can prevent investors from achieving their long-term goals as they fall into potential traps. This article will shed light on—and help address—some of the more common behaviors that often impact the investment decision-making process and lead to poor outcomes, as well as provide insight into how to overcome these traps.

Data has shown that investors as a whole continue to buy and sell at exactly the wrong time. While we cannot know the specific reasons why, even a shallow understanding of the human psyche offers some answers.

Investors tend to react to news—good or bad—without doing any analysis. They can be mesmerized by long-running bull markets and absolutely unnerved by bear markets. They may try to match the investment acumen of their relatives, neighbors, friends, business associates, or even strangers—anyone who claims, even casually, to have done well in the market.

A study published by Morningstar’s Russell Kinnel on Feb. 4, 2013, found the same problem: Investors as a whole do quite poorly compared to indexes. Across all funds, the average investor lagged the average fund by 0.95% annualized over the previous 10 years.

Source: Morningstar

Most investors fail to maintain the discipline needed to follow a systematic approach that helps them detach their emotions from their decisions. Common investor faults include:

• Lack of discipline
• Impatience
• Greed
• Refusal to accept the truth
• Lack of objectivity
• Impulsive behavior
• Drawing false parallels

Books are filled with many more and cover them with much more detail, but these are the ones I have seen most often, with lack of discipline being the most damaging.

Your brain can play tricks on you. If you frequently take an escalator or moving sidewalk when going to work, you know the feeling. Your brain triggers an automatic (involuntary) action as you step on, and you may not even notice it. But what if one day the escalator is stopped? You may almost stumble as you step onto it, even if you notice that it is stopped, because your brain is programmed to assist. But this time, that assistance is not helpful.

One critical solution to overcoming flawed investor behavior is having a proven, disciplined, repeatable process that guides decision-making without emotion. Discipline keeps your emotions in check and your perceptions clear. But discipline requires intellectually identifying a process you trust, then sticking with it in good times and bad, even when your emotional biases begin railing against it. No strategy is always perfect.

In January 2013, a study titled “Head and Shoulders Above the Rest? The Performance of Institutional Portfolio Managers Who Use Technical Analysis” looked at more than 10,000 institutional portfolios. About one-third of actively managed equity and balanced funds use technical analysis. The study found that funds using technical analysis appeared to have provided a meaningful advantage over those that did not.

It is critical for investors to acknowledge the possibility that deep-seated behavioral flaws can negatively impact investment decision-making and that, without discipline, the investment process may be doomed to fail. I explored these human failings and heuristics further in a series of articles titled “Know Thyself,” “Know Thyself II,” and “Know Thyself III.”

The opinions expressed in this article are those of the author and the sources cited and do not necessarily represent the views of Proactive Advisor Magazine. This material is presented for educational purposes only.

This article by Greg Morris was published at StockCharts.com on July 22, 2022. Many thanks to the author and StockCharts.com for permission to republish an edited version of the article. Please see many other commentaries by Mr. Morris on the blog Dancing with the Trend.