May 20, 2020
We all know that financial health is one of the key factors to a good and happy retirement. Taking care of your finances now will ensure that you will be worrying less about money and caring more about being happy. Unfortunately, some investors make mistakes that could be detrimental to their retirement.
In part 1 of the common investment mistakes series, we delve into Active Trading and Familiarity Bias. Researchers for some time have studied investment behavior and identified these common investment mistakes. Now you can use this information to add to your arsenal to become a better, and more informed investor.
According to one study by Brad Barber and Terrance Odean, major figures in the field of behavioral finance, active traders underperform the market.1 In “Online Investors: Do the Slow Die First?” Barber and Odean determine that investors who use traditional brokers, remaining in touch with them by telephone, achieve better results than online traders, who damage their performance by trading more actively and speculatively.2
When an individual’s investment preferences are based on what is familiar, favoring their own country, region, state, and company, behavioral finance specialists characterize this preference as “familiarity bias.”
Gur Huberman, a professor of behavioral finance at Columbia University, found in his study, “Familiarity Breeds Investment,” that investors in 49 out of 50 states are more likely to invest in their local Regional Bell Operating Company (RBOC) than of any other single RBOC.3
Another form of familiarity bias is employees’ preference to invest in their employer’s stock. In the report, Behavioral Patterns and Pitfalls of U.S. Investors, it says “Employees already have a stake in the performance of their companies without including company shares in their investment portfolios. Not only does concentration in one asset violate the principle of portfolio diversification, but if employees devote a large portion of their portfolios to their own company’s shares, they run the risk of compounding their suffering if the company does poorly: first, in loss of compensation and job security, and second, in loss of retirement savings. This is exactly what happened to employees at Enron® and Fannie Mae, when Enron filed for bankruptcy in 2001 and when Fannie Mae was placed into government conservatorship in 2008.” 4
Why do people make this mistake? We’re sure the reasons are numerous, but in “Are Empowerment and Education Enough? Underdiversification in 401(k) Plans,” the authors contend that employees invest in company stock for a variety of reasons, including familiarity bias, loyalty to their employers, naive-diversification strategies, and passivity. In addition, the company shares some of the blame. They encourage investing in employee stock-ownership plans (ESOPs) and employers’ matching contributions.5
As financial advisors, we have seen or read about many investor mistakes. Part 2 and 3 will reference more of these common investor mistakes.
If you are concerned that you might be making similar mistakes, or just need a second opinion on your portfolio, please contact our office.
1 Brad M. Barber and Terrance Odean, “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance 55, no. 2 (April2000): 773-806.
2 Brad M. Barber and Terrance Odean, “Online Investors: Do the Slow Die First?” Special issue, Review of Financial Studies 15, no. 2 (2002): 455–87.
3 Gur Huberman, “Familiarity Breeds Investment,” Review of Financial Studies 14, no. 3 (Autumn 2001): 659–80.
4 “Behavioral Patterns And Pitfalls of U.S. Investors,” a report prepared by the Federal Research Division, Library of Congress at: http://www.sec.gov/investor/locinvestorbehaviorreport.pdf