There are a lot of behavioral biases out there, and it may seem like researchers take an unusual amount of pleasure in pointing them out to us. Our investments, for example, are subject to everything from overconfidence to herd behavior, from the "home bias" of preferring local investments to our strange penchant for gambling on long shots (which are, of course, always a sure thing at the time).
But what if only two of them really mattered? A recent study suggests just that. The key offenders? Under-diversification and lottery stocks, which together can reduce your performance by up to 7% per year.
What's behind this, and how can you fix it?
Uncovering the roots of poor returns
The study in question covers 12 years of trading and performance data in 5,000 German investment accounts. Before you protest, it should be noted that the study demographics look very similar to those of American investors. The data also capture another important twist: most people don't just invest in stocks. They have mutual funds and bond allocations, and this study looks at all of it.
It's a huge statistical effort to untangle the 10 behavioral biases the researchers focused on, but at the end of the day (and after a lot of math) they found that these two little quirks were the big undoers of portfolios across Germany.
So, what do you do about it?
Well, first of all, diversify
By eliminating this bias altogether, the least diversified investors in the study could have improved their performance by 4% per year. Mileage will vary, as it depends how under-diversified you are right now, but that's a pretty significant change for not very much work.
Diversification means investing across asset categories that aren't highly correlated. In this sample, the average normalized returns variance (don't be afraid, it's just a fancy name for a simple concept: it tells you how much the returns of different assets in a portfolio vary from each other) is 0.55, which is rather high. A normalized return variance of 1.0 means that all the returns are perfectly correlated, whereas 0.0 means that they are completely uncorrelated. In other words, most people's returns were pretty correlated -- when one holding moved up, the others were likely to do the same.
Why should this matter? After all, you could also boost returns by diversifying less but picking the right investments. Diversification can also boost returns by picking the right investments. But this study also looked at forecasting ability, and the conclusion is that, unfortunately, most investors aren't really good at picking. Even when we're right sometimes, we are simply not right all of the time.
"As hard as it is to always be right, it should also be hard to always be wrong. Less-diversified investors then suffer more from the mistakes they make and realize lower returns than their better-diversified counterparts without needing to be substantially less skilled."
In other words, diversification matters because it helps mitigate the possibility of being wrong. Do yourself a favor: Instead of being 100% sure that XYZ industry or sector of your choosing is for sure going to be a winner, diversify. You'll still get to enjoy the benefits of being right, but you'll also be spared the potential pain of being wrong.
Stop chasing the long shot
Your proportion of "lottery stocks," or those low-priced, highly volatile wild-cards, is a nice measure of your preference for gambling. Unfortunately, like the lottery, they also rarely pay off.
Eliminating (or even reducing) your little hobby could actually improve performance by 3% a year. This is especially the case if you tend to go a bit crazy with it -- people who have the most lottery stocks tend to fare the worst. This is probably because of the nature of returns for these stocks: not only are they volatile, but their returns tend to be skewed, meaning that most of the time you lose.
So, think about stepping away from the buy button on your next sure thing. It could end up buying you an extra few percentage points a year.
Caveats
Of course, both investing and behavior are complicated, and our quirks and biases tend to function in tandem. For example, the researchers found that people who invest in lottery stocks are also more likely to trade more often and diversify less. On the other hand, those who excel at forecasting tend to trade less, buy fewer lottery stocks, and stick closer to home.
While much of this is teased out in the analysis, you can never be entirely sure of what's going on with you. The point is, your individual failures and good fortunes might be tied to more than just these two behaviors -- and these behaviors could be symptomatic of other quirks that are holding you back.
However, if you want to try and juice your returns without shooting yourself in the foot, more diversification and less gambling might just be the hottest, if most prosaic, tips around.
