This investment insight delves into behavioral finance and the emotional side of investing.

  • The emotions that may lead human beings to believe they can outperform the market are the same emotions that may also unconsciously lead them to make poor investment decisions.
  • There are a number of steps that you can take to protect yourself from the inherent biases and natural human emotions that lead to investment mistakes.
  • Partnering with those who are used to the ebbs and flows of financial markets should help keep your investments on a rational, unemotional keel.

According to the theory of efficient markets, where independent news flows freely and markets are fairly valued, it is impossible to “beat the market” through expert stock selection. Left to their own devices, markets would probably be nothing but rational, with trading wholly justified by universally available information.

However, there is a gap between what should be and what is, between decisions made in a theoretical marketplace that seeks to optimize a rational outcome and decisions made by human beings—with all their fear, greed, vulnerabilities, egos, and weaknesses.

Out of this gap was born a body of research on “behavioral finance” by psychologists Amos Tversky and Daniel Kahneman, who studied the effects of human biases and emotions on market participants. Mr. Kahneman won the Nobel Prize for this work in 2002; Mr. Tversky passed away in 1996. 

The irrational investor
The emotions that may lead human beings to believe they can outperform the market are the same emotions that may also unconsciously lead them to make poor investment decisions. Let’s consider the example of two hypothetical experienced investors who managed their own investments. They thought they were doing quite well, until a closer look at the performance of the mutual funds they’d invested in showed that the returns they had earned were less than the funds’ actual returns. This situation is not unusual.

In a Morningstar study published in March 2018, the gap between official total returns and those actually experienced by investors across all mutual funds has shrunk to 26 basis points (bps) over the prior ten years. For example, U.S. equity funds show a robust 8.3% annualized investor return, a modest gap compared to the 8.9% for the average equity fund. Since 2014, the gap has improved for U.S. equity, balanced, and muni bond funds, while worsening for international equity and taxable bonds.

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