Your investment portfolio may need variety to help fit your needs. Too much of one kind of asset, or too little, and you’re likely to find yourself without the pieces that can potentially help you meet your long-term financial goals.
The trick is to guard against making decisions based on trends or biases you might not be aware you have. Tracie McMillion, head of Global Asset Allocation for Wells Fargo Investment Institute, took a closer look at some of the biases that can cloud your thinking:
Identify your biases
Even savvy and knowledgeable investors can be blind to their own biases — tendencies that can thwart smart decision-making. Common investment biases include:
Sector bias. All too often, professionals gravitate toward stocks in industries that they’re most familiar with. Doctors, for instance, may load up on health care stocks.
• Risk: You may lose out on potential earnings in other industries and unduly expose yourself to downturns in industry-specific markets.
• Consideration: The key is to diversify among sectors. Work with your investment professionals to gain an understanding of how assets in various sectors may potentially help a portfolio perform better as a whole over the long term.
Company bias. From favoring a family business to maintaining too much loyalty to a long-time employer, this bias can weigh down a portfolio with one company’s stock.
• Risk: Sinking too much of your retirement savings into one brand can leave you exposed to company-specific volatility risk that can be sizable. It can even expose your portfolio to the possibility that that one company may cease to exist.
• Consideration: Diversification may potentially help buffer the effects of severe problems at an individual company level.
Bias toward recent events. Called “recency bias,” this tendency relates to how investors respond to everyday market activity. With investment information and the news of national and international events at our fingertips 24/7, many of us are very tuned in to what’s happening in the world — and in the financial markets.
As human beings, we tend to project what has just happened into the future, reacting to upward and downward trends by buying and selling stocks as if yesterday’s good or bad news will continue into the future.
• Risk: Letting short-term news drive your investment decisions could cause you to abandon your personalized, long-term investment plan.
• Consideration: Self-discipline. Work with your financial team to create a personal investment philosophy statement — and stick to it. This customized strategy should account for your desired asset mix, risk preferences, liquidity needs, and time horizon. And it can help you keep your cool when the headlines start to heat up.
Home country bias. Investors — be they American, Italian, or Brazilian — typically feel most comfortable when they choose to invest in companies headquartered in their home countries. After all, they’re usually the companies that such investors read about in local or national media and the companies that they do business with as consumers most often.
• Risk: Home country bias may translate to missed investment opportunities. Heavy reliance on U.S. stocks, bonds, and real estate can keep you from expanding your investment strategy to take advantage of global investment opportunities.
• Consideration: We believe it’s a good idea to see to it that most of your assets have some global component. And remember that while currency exchange rates may introduce risks to your portfolio, they also may pave the way toward enhanced returns.
Some additional caveats
In addition to these biases, we see other habits and attitudes that can affect our clients’ portfolios. You may not be susceptible to all of these tendencies, but being aware of them can help keep your investment strategy on track:
• Overconfidence. Do you think you can beat the Street? Striving to micromanage your portfolio stock-by-stock or trying to outsmart the market in a short time frame is a common, but often flawed, tactic in our view. Instead, trust your plan and don’t try to anticipate short-term market movements.
• Aversion to loss. Is there an asset you just can’t bear to sell because it has lost value? Well, with each passing day, you could be putting off the inevitable, and in our view, you may be robbing yourself of access to investment dollars that could be working for you elsewhere. Ask yourself if it’s time to move on.
• Anchoring. This tactic comes into play when you hold on to an investment because you are comparing its current value to a reference value, such as a top-dollar price point from the past. Anchoring thinking might go something like this: “I just want the stock price to return to the high it hit two years ago before I sell.” But by mooring yourself to a potentially unrealistic expectation, you may find that your investment plan doesn’t move forward.
• Favoritism in asset classes. Are you showing preference for one type of asset over others? Do you have “rules” against investing in certain asset types? Showing favoritism may unnecessarily exclude a choice — including a new investment strategy — that could serve you well. Our goal is to help clients make their investment plans personal without allowing such unintentional biases and tendencies to creep in. The overall solution comes back to self-control during volatile times. Work with your investment team to maintain objectivity, manage risk, and stay focused on long-term goals rather than toward short-term investment — or emotional — rewards.
More about creating your personal investing philosophy
To help provide focus and direction, every investor should consider establishing a personal investment philosophy. For couples, the philosophy statement should reflect their mutual investment goals and their unified strategy as a household.
Here’s a short list of action items that can get you started on formulating your personal investment strategy.
• Determine how much cash you need to hold to your commitment to your long-term investment plan. Before and during retirement, you may need to tap cash holdings to pay for living expenses, emergencies, or other major planned expenses, such as a son’s or daughter’s wedding. We call the amount of cash that you may need to access “your sleep-well number” — the figure that may allow you to feel more at ease regarding your investment plan.
• Commit to diversification of your investments. Not to sound repetitive, but this tactic can help you deal with market ups and downs. Just as you need an overcoat in winter and a swimsuit in summer, various assets simply tend to perform better during different economic cycles. So position yourself for different financial seasons with a diversified combination of fixed income, equity holdings, real assets, and alternative investment strategies.
• Actively manage risk. Don’t forget to revisit and rebalance your portfolio about once a year and when you experience a major life event. Reallocation can help your portfolio stay on plan and reduce risk or enhance return potential when markets have moved significantly.
• Weave goals into your overall plan. Many investors who have significant resources also have aspirations of making their world a better place. To understand how you spend your investment dollars, consider asking a financial advisor to run screens on your complete portfolio, including investments, charitable trusts, and asset transfers. Then collaborate on any adjustments needed to help the overarching investment plan operate within your customized preferences.
Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
This article has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Individuals need to make their own decisions based on their specific investment objectives, financial circumstances, and tolerance for risk. Please contact your financial, tax, and legal advisors regarding your specific situation.
All investing involves risk, including the possible loss of principal.
Stock markets, especially foreign markets, are volatile. Stocks may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging and frontier markets.
Equity securities are subject to market risk, which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.
Investments in fixed-income securities are subject to market, interest rate, credit and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can cause a bond’s price to fall. Credit risk is the risk that an issuer will default on payments of interest and/or principal. This risk is heightened in lower rated bonds. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Asset allocation and diversification are investment methods used to help manage risk. They do not guarantee investment returns or eliminate risk of loss including in a declining market. All investing involves risk including the possible loss of principal.
There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions.
Alternative investments, such as hedge funds, funds of hedge funds, managed futures, private capital, real assets and real estate funds, are not appropriate for all investors. They are speculative, highly illiquid, and are designed for long-term investment, and not as trading vehicle. These funds carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. The high expenses associated with alternative investments must be offset by trading profits and other income which may not be realized. Unlike mutual funds, alternative investments are not subject to some of the regulations designed to protect investors and are not required to provide the same level of disclosure as would be received from a mutual fund. They trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the fund and the investor. An investment in these funds involve the risks inherent in an investment in securities and can include losses associated with speculative investment practices, including hedging and leveraging through derivatives, such as futures, options, swaps, short selling, investments in non-U.S. securities, “junk” bonds and illiquid investments. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Other risks can include those associated with potential lack of diversification, restrictions on transferring interests, no available secondary market, complex tax structures, delays in tax reporting, valuation of securities and pricing. An investment in a fund of funds carries additional risks including asset-based fees and expenses at the fund level and indirect fees, expenses and asset-based compensation of investment funds in which these funds invest. An investor should review the private placement memorandum, subscription agreement and other related offering materials for complete information regarding terms, including all applicable fees, as well as the specific risks associated with a fund before investing.
