The Library of Congress’s Federal Research Division recently prepared a report on the behavioral traits of U.S. investors, at the request of the SEC’s Office of Investor Education and Advocacy. The Library of Congress’s report identifies common investing mistakes that can undermine investment performance. The report is based on research and analysis adhering to accepted standards of scholarly objectivity.
The undermining behaviors are·Active Trading: An investor using an active trading investment strategy engages in regular, ongoing buying and selling of investments. This kind of investor purchases investments and continuously monitors their activities in order to take advantage of profitable conditions in the market. The Report concludes that active trading generally results in the underperformance of an investor’s portfolio.
- ·Disposition Effect: The disposition effect is the tendency of an investor to hold on to losing investments too long and sell winning investments too soon. In the months following the sale of winning investments, these investments often continue to outperform the losing investments still held in the investor’s portfolio.
- ·Focusing on Past Performance of Mutual Funds and Ignoring Fees: When deciding to purchase shares in a mutual fund, the Report indicates that some investors focus primarily on the mutual fund’s past annualized returns and tend to disregard the fund’s expense ratios, transaction costs, and load fees, despite the harm these costs and fees can do their investment returns.
- ·Familiarity Bias: Familiarity bias refers to the tendency of an investor to favor investments from the investor’s own country, region, state or company. Familiarity bias also includes an investor’s preference for “glamour investments”; that is, well-known and/or popular investments. Familiarity bias may cause an investor’s portfolio to be inadequately diversified, which can increase the portfolio’s risk exposure.
- ·Manias and Panics: Financial “mania” or a “bubble” is the rapid rise in the price of an investment,
reflecting a high degree of collective enthusiasm or exuberance regarding the investment’s prospects. This rapid rise is usually followed by a contraction in the investment’s price. The contraction, or “panic” occurs when there is wide-scale selling of the investment that causes a sharp decline in the investment’s price. - ·Momentum Investing: An investor using a momentum investing strategy seeks to capitalize on the continuance of existing trends in the market. A momentum investor believes that large increases in the price of an investment will be followed by additional gains and vice versa for declining values.
- ·Naïve Diversification: Naïve diversification occurs when an investor, given a number of investment options, chooses to invest equally in all of these options. While this strategy may not necessarily result in diminished performance, it may increase the risk exposure of an investor’s portfolio depending upon the risk level of each investment option.
- ·Noise Trading: Noise trading occurs when an investor makes a decision to buy or sell an investment without the use of fundamental data (that is, economic, financial, and other qualitative or quantitative data that can affect the value of the investment). Noise traders generally have poor timing, follow trends, and overreact to good and bad news in the market.
- ·Inadequate Diversification: Inadequate diversification occurs when an investor’s portfolio is too concentrated in a particular type of investment. Inadequate diversification increases the risk exposure of an investor’s portfolio.
