Investors can boost their outcome by resisting behavioral pitfalls, avoiding hyped stocks, and looking for underappreciated signals.
How to Avoid–and Benefit From–Common Behavioral Mistakes
In the portfolio, I would say there are three classic errors. The first is individuals often own too much of their own company stock, and that’s due to a familiarity bias that comes from the affect of, you like things you’re more familiar with. People do this: They tend to buy more stocks that are centered in their hometown. They tend to buy stocks that are in their states, stocks that are in their own country. And in particular they often buy the stocks that they themselves work for. That can be very dangerous. First of all, your human capital is intimately tied up with the success of that stock, but also it can lead to a lack of diversification.
The second classic error is known as the endowment effect, and that is, people tend to value things they have more than the things that they might get. … There is some research on this, many classic experiments, but where it applies in the stock market is that perhaps people inherited something from when their grandmother passed away, perhaps they’ve had a stockholding that’s grown to be a very large percentage of their portfolio, and they don’t get rid of it because they fell like, well, I have it, and they’re overly attached it, and that can lead to very lopsided portfolios as well. You can see how that could interact with the company stock also.
The third classic error in portfolios is the disposition effect. That is holding on to losers too long, and the reason is, people don’t like acknowledging a mistake, and they sort of think incorrectly that if they just never sell it, they don’t have to book the loss. Conversely, people tend to not hold on to their winners long enough. They like to be able to say, I checked the box, I made a profit, that’s good. And that’s something that people need to watch out for. I might add that the disposition effect goes completely against tax-planning as well. People actually would benefit perhaps from selling some of their losers, but they don’t because of this emotional reason (Source: Morningstar interview of Fuller & Thaler director of research Raife Giovinazzo).