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September 20, 2014

Don't Let Bias Ruin Your Investment

There is a new study about superstitions and portfolio returns. It should not surprise you to hear that superstitious individual investors have worse performance than those who are not superstitious. Any time biases are introduced into financial decision making, returns will be affected.
The study looked specifically at Taiwanese traders. The researchers found a far higher ratio of orders placed at prices ending in the number eight than they did for orders ending in the number four. This was attributed to the fact that Chinese culture views the number “8” as lucky and the number “4” as unlucky. The researchers noted that in Mandarin, “four” is pronounced similar to “death,” whereas “eight” is pronounced similar to “good fortune.”
Traders who were the most superstitious trailed investors who were the least superstitious on an intraday, one-day and five-day basis. The reason is simple. The superstitious traders let their biases toward certain numbers govern their investing decisions, rather than making purely objective choices.
The study’s authors pulled no punches when discussing the results. They called superstitions “a separate dimension of an investor’s cognitive disability in making financial decisions.”
It’s not fair to solely call out Taiwanese traders for being superstitious. A bias toward or against certain numbers exists in many cultures and religions. Here, in the United States, 13 is viewed as an unlucky number. Some buildings go so far as to rename their 13th floors to avoid having it as an option on elevators, including our own office building. Conversely, 13 is a lucky number in many other countries, as is three. It is not uncommon for a Jewish person to give monetary gifts or make donations in multiples of 18. Based on anecdotal evidence, it seems fairly common for people to use birthdates when choosing lottery ticket numbers.
It has been well-proven that we humans use heuristics when making decisions. Our minds have evolved to seek and identify patterns. Doing so has helped us survive, but it has also left us with biases that lead to incorrect decisions. Scientific American recently wrote about a study showing a chimpanzee outplaying a human competitor in a brain game. 
We’re intellectually superior to chimps in most ways. The downside of our intellect is that we can let our biases interfere with what should be purely rational decisions. As such, you should be careful about letting biases influence your decisions (and generally trying to outthink yourself or the potential actions of others.) For example, it’s not uncommon to see great companies have stocks that are risky or otherwise unappealing investments. On the other hand, just because you don’t like an industry doesn’t mean you should avoid it. The stocks within it might be great investments.
The one exception is social investing. You need to invest in a manner that allows you to sleep at night. If buying shares in a certain company puts you at odds with your morality or other closely held beliefs, don’t do it. Realize, however, that by doing so you restrict the number of investment options available to you and that, in turn, could harm your portfolio’s performance.
The Week Ahead

On Thursday, Nike (NKE) will be the first Dow component to report earnings this earnings season. Joining it will be fellow S&P 500 members AutoZone (AZO) on Monday; CarMax (KMX), Bed Bath & Beyond (BBBY) and Carnival Corp. (CCL) on Tuesday; Jabil Circuit (JBL), Paychex (PAYX) and Accenture (ACN) on Wednesday; and Micron Technology (MU) on Thursday.
The week’s first economic report of note will be August existing home sales, released on Monday. Tuesday will feature the PMI Manufacturing Index Flash. August new homes sales will be announced on Wednesday. Thursday will feature August durable goods orders. The University of Michigan’s final September consumer sentiment survey and the final estimate of second-quarter GDP will be released on Friday.
Several Federal Reserve officials will make public appearances: New York president William Dudley and Minneapolis president Narayana Kocherlakota on Monday; Governor Jerome Powell and Kansas City president Esther George on Tuesday; Cleveland president Loretta Mester and Chicago president Charles Evans on Wednesday and Atlanta president Dennis Lockhart on Thursday.
The Treasury Department will auction $29 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday, and $29 billion of seven-year notes on Thursday.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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