The importance of removing bias and creating a portfolio
After five years in Students in Money Management (SIMM), I wanted to share some of the most important things I’ve learned to help with your investment portfolio.
Before you start investing, you must have a plan. Think about the purpose of a portfolio. Is it for retirement? For fun? After deciding, come up with a few goals to achieve. Those goals could be to have $1 million for retirement or maybe $60,000 in your daughter’s 529 college fund. This is important because your goal will determine your allocation of the portfolio. A goal of $10 million at retirement versus $1 million will have much different risk profiles. The portfolio trying to obtain $10 million will require taking more risk opposed to the $1 million portfolio. This will help determine what percentage of stocks, bonds or other instruments that one invests in. Whatever purpose you decide for your portfolio, start investing as early as possible. As Albert Einstein said, “Compound interest is man’s greatest invention.”
There are many biases that affect us and often multiple biases at once. What affects people the most when it comes to investing is loss aversion. The concept behind loss aversion is that losses hurt more than gains. Meaning that if the investment loses $100, you feel worse about it than feeling good if the investment made $100. Therefore, investors often hold onto losers because they hurt more than winners. An example of a different bias in play is home bias. Home bias refers to investors choosing to invest in domestic securities because they are more familiar with them than foreign investments. If you watched the Kentucky Derby last weekend, you may have noticed the horse Master Fencer was from Japan. Master Fencer’s odds to win the derby were 58-1 in the U.S. Meanwhile, in Japan Master Fencer’s odds to win were 27-1. Since many gamblers in Japan were familiar with Master Fencer, it led to more bets on the horse domestically opposed to the United States. Knowing that you’re biased is half the battle. The other half involves setting measures in places to help prevent your human biases from negatively affecting your investment portfolio.
To effectively prevent yourself from yourself in investing, you can do a couple of things. For individual investments, you can implement a stop loss. A stop loss is a type of order that tells your broker to sell a stock or other investment if it drops below a certain price. There is no fee for a stop loss order; you can simply set it on your brokerage account. This is a no-brainer since most of us will be affected by loss aversion and would most likely hold onto losses hoping they will recover. The stop loss takes that bias out by selling your investment at the price originally set. Stop losses are great for helping you stick to your original investment plan.
The easiest and most effective plan of eliminating bias from an investment portfolio is hiring a financial advisor. A financial advisor will not only help with your investments, but also can help with planning elements.
It’s beneficial to have someone else manage your money simply because it’s not theirs. A financial advisor doesn’t have the same attachment to your money as you do, although they can still have the same level of care.
Since financial advisors are less emotionally attached to your investments, they aren’t as susceptible to biases that you experience if you manage them yourself. This, in turn, may help produce better investment portfolio returns than investing your own money.
Speaking of investment returns, everyone loves high returns. People are always looking to make it rich quick; it’s our human nature. Think back to how many times your mother told you that get-rich-quick schemes were fake. Turns out mom was both right and wrong after all. Mom was wrong because get-rich quick-investments are possible. Maybe you invested in Bitcoin at the right time, although not likely. Well, in the end mom was probably right. Investments can’t make you rich quickly with little downside risk. Because of the risk to return tradeoff, you either get rich quickly or get poor fast. This is important to take into consideration when investing. If the investment can make you rich fast, it can also make you poor fast. Next time your brother-in-law gives you the next hot-stock tip, tell him to try this one on for size.
Circling back to Bitcoin, it’s important to take note of another bias that many of us succumb to: herding bias. This bias involves following whatever the crowd is doing, thinking that if everyone else is doing it, I should be doing it too. Bitcoin happens to be the most current example of a bubble caused by herding bias.
One of the most well-known bubbles in history occurred in the 17th century with tulip bulbs where they were sold at 50 times their starting value. Similarly to Bitcoin, everyone piled into tulip mania to try to get in on the action. The result ended in tulip prices falling dramatically down back toward their starting value. It’s often very difficult to know when we’re in a bubble, but it helps thinking about getting rich fast or getting poor fast to recognize one. Or you could listen to your mom again… If Bitcoin jumped off a cliff, would you jump too?
By Adam Talmadge, Staff Writer
talmadaj14@bonaventure.edu
