If you invested dispassionately, using an objective analysis of the historical data, you would invest in a globally diversified portfolio of index funds with low management fees. It's not that you can't beat the market by investing in actively managed funds. Every year, some mutual funds outperform their benchmark. However, their probability of doing so over the long term is relatively low. Over a 20-year period, about 80 percent of actively managed funds will underperform their benchmark, Charles Ellis wrote in a 2012 article published in Financial Analysts Journal.
It gets worse. If you make the wrong pick and your fund underperforms, the underperformance is likely to be significantly greater than the outperformance of the minority of funds that beat their benchmark.
You would expect professional or "institutional" investors to have a better track record of beating the market, but they don't. The same research from Charles Ellis on institutional portfolios found that only 1 percent of the funds they chose "achieve superior results after costs."
It may seem that individual and institutional investors are acting irrationally by chasing returns, but that would be incorrect.
1. Anchoring. Anchoring describes the tendency to focus on one factor when making decisions, while ignoring other factors that may be of equal or greater importance. Examples of anchoring in investing abound, stimulated largely by the financial media. References to stocks being "overbought" or "oversold" are examples of anchoring. These factors may or may not be logically related to the future price of the stock.
2. Overconfidence. In my experience, overconfidence is the trait that probably does the most harm to investors. When gold was at its peak in September 2011, one of my clients at the time instructed me to sell her diversified portfolio, closed her account and opened a new one with a broker specializing in gold. She told me it was "obvious" we were on the brink of an international depression, and gold was the only safe haven.
Unfortunately, when the subject is investing, many people believe they are experts, even though most have no training in finance. Their overconfidence often causes them to make unwise investing decisions. There is also evidence that men are more prone to overconfidence than women, according to a 2001 research paper by Brad Barber and Terrance Odean named "Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment."
3. Hindsight Bias. Hindsight bias refers to our tendency to take facts now known and interpret them in a way that explains past events. This is a particularly dangerous bias because it causes us to believe we have more control over the future, due to our belief that we can explain the past.
Many clients tell me the 2008 financial recession was inevitable, yet few predicted it at the time and took action to protect themselves from the market crash. Undeterred, these same investors now have strong opinions on the future direction of the markets, even though tomorrow's news will play a significant role in determining stock prices, and no one knows what that news will be.
4. Representativeness. Investing is complicated. There is a human tendency to look for shortcuts, instead of sifting through all the variables, by placing undue emphasis on one or two qualities and filtering all information through those categories. For example, if a particular asset class has performed well or poorly recently, you may be inclined to categorize information about a stock and put it into the category of a "strong" or "weak" performer, even if there are many other issues you should be considering.
5. Herd Behavior. Herd behavior occurs when investors follow the behavior of a larger group, even in situations in which it may be difficult to rationally justify the decisions of the group. A classic example of herd behavior occurred in the 1990s. Investors poured huge assets into the stocks of fledgling Internet companies, even though many of them didn't have any profits and were unlikely to generate significant revenues in the foreseeable future.
There are many adverse consequences of herd behavior. They include high transaction costs, which happens when everyone tries to keep pace with the latest hot trends. Focusing on the conduct of the herd, instead of fundamentals that are more relevant considerations, will likely result in disappointing returns.
Understanding the role that behavioral finance plays in your investing decisions is a critical first step. Many investors don't realize they are engaging in these biases, much less appreciate how they inhibit intelligent, responsible and evidence-based investing choices. All investments carry an element of risk, but you can become a better investor if you are aware of these powerful forces that operate in your subconsciousness.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, "The Smartest Sales Book You'll Ever Read," will be published March 3.