Investing habits: The good and the bad

Choosing good investments is a necessary condition for successful investing. But it's also important to engage in good behavior once those investments have been selected.

The most recent issue of AQR Capital Management's quarterly newsletter for clients provides great insight into both the bad behaviors investors tend to engage in, as well as positive practices that can be used to address and correct bad habits and biases -- leading to improved long-term investment performance.

We'll first look at the bad behaviors.

Performance Chasing

Extrapolating from the recent past to anticipate future performance is one of the strongest behavioral biases. It isn't surprising that investors, both individual and institutional, tend to buy the last three-to-five years' worth of winners and sell multi-year laggards -- whether it is asset classes, strategy styles, single stocks or funds.

While there is strong evidence of short-term momentum -- measured in months, not years -- over the longer term an asset's return to its mean becomes more likely. Cash inflows from performance chasers tend to make expensive assets in bull markets even more expensive and cheap assets in bear markets even cheaper.

This can lead an investor to buy an asset at its top (high) and sell it at its bottom (low). For example, the 2008 study by Andrea Frazzini and Owen Lamont, "Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns," found that when sorting stocks between lowest-quintile and highest quintile based on the past three years of inflow, high-inflow stocks underperform low-inflow stocks over the next month by 0.85 percent (which is 10 percent per year). The main underperformance occurs six to 30 months after the inflow. Numerous studies have found that investor returns lag the returns of the investments they make -- what my colleague, and fellow author, Carl Richards called The Behavior Gap in his book by that name.

Even institutional investors -- who are, after all, human beings subject to the same behavioral errors -- engage in this destructive behavior. Research has found that the managers fired by pension plan sponsors, typically based on three-year performance evaluations, subsequently go on to outperform the managers hired as their replacements.

In addition, the 2014 study "Asset Allocation and Bad Habits," by Andrew Ang, Amit Goyal and Antti Ilmanen, found that a positive return in one asset class (domestic or international stocks or bonds) results in an increase in target policy weights of that asset class. And not just in the same and subsequent year, but for several years.

A recent issue of Pensions & Investments reported that the target dates funds, including those run by industry leaders such as Black Rock, Fidelity, PIMCO and J.P. Morgan, were raising their equity allocations. Clearly, target date funds are subject to the same bad behaviors.

Underdiversification

Despite the well known and obvious benefits of diversification (it's often referred to as the only free lunch in investing) many investors tend to concentrate their portfolios. This mistake, which can be costly, is often caused by confusing the familiar with the safe.

Unfortunately, iconic fund manager Peter Lynch contributed to this problem with his advice to "buy what you know." Being familiar with an investment may provide you with information. But that doesn't mean that the information is what economists would call "value relevant." If others have the same information (which is almost certainly the case, unless it's inside information) it's already embedded in the price, and thus has no value to you.

Confusing the familiar with the safe can entice investors to concentrate risk. For example, home country bias can lead investors to overweight, often dramatically, the equities of their domestic market. Note that this investment mistake is a world-wide phenomenon. Investors all over the globe tend to overweight their domestic market, each believing (illogically) their home market is both safer and will provide higher returns.

A second and related mistake is overweighting the stock of the company you work for. That's a particularly egregious error, because it combines investment risk and employment risk. That can put investors in double jeopardy because both these risks can show up at the same time.

Seeking Comfort

Investors often favor popular assets. AQR explains: "It is never fun to lose money but it is even worse to be "wrong and alone." They also noted famed economist John Maynard Keynes' warning about "the dangers of failing unconventionally."

Favoring popular assets can cause investors to concentrate their holdings in the more glamorous growth stocks, rather than the higher returning and unglamorous value stocks. Anyone looking at the list of stocks in a value index fund might be scared off by the names on the list. I've often heard comments along the lines of, "Why would you want to own such dogs?" And this from prospective clients who actually looked at the stocks in the value funds we recommend. Holding such "dogs" can be a source of discomfort, while owning Google can give you bragging rights at cocktail parties.

Seeking comfort also leads investors to overpay for products that provide downside protection, such as variable annuities with guaranteed minimum payments, against what are referred to as left-tail risks. Overpaying leads to poor returns. What's interesting is that while investors overpay for insurance (demonstrating aversion for risk) they also overpay for investments with lottery-like distributions (demonstrating desire for risk). Investments with lottery-like distributions include IPOs, extreme small growth stocks, penny stocks and stocks in bankruptcy.

Seeking comfort in the form of smooth returns may also be why investors overpay for illiquid, private equity investments. The fact that returns are not reported frequently and valuations may not be adjusted to true market value, may lead to the appearance of smoother returns than is actually the case. The same effect occurs when investors buy a long-term CD instead of a bond with a similar maturity. When the investor receives their custodial statement, the bond will be marked-to-market while the CD they own directly will not. The CD provides an illusion of safety in a rising rate environment. Similarly, private equity investments can provide an illusion of smooth returns.

AQR also highlights three good practices that investors should adopt in their pursuit of financial success.

Invest Strategically

Investors should choose the strategy and asset allocation they believe in and stick to it, avoiding tactical asset allocation or market timing strategies. To ensure you have the discipline required to do so, you must be sure to not accept more risk than you are willing or able to take. Strategic investing also requires rebalancing, which leads to the opposite of the destructive performance-chasing behavior in which most investors engage.

Diversify Risks Aggressively

In a world where there are no clear crystal balls, broad global diversification is the prudent strategy. And it should be thought of in terms outside of just simple geography. Diversification should be applied across asset classes, to equity factors beyond overall equity market risk -- factors such size, value, momentum, and profitability -- and to strategies, such as the carry trade.

Accept Discomfort If You're Paid For It

Where there's strong, persistent and pervasive evidence of a premium for a certain strategy, or factor, be willing to take risk. But do so only to the point where you don't exceed your ability, willingness or need. The ability to hold uncomfortable assets (such as value stocks) during difficult periods is often what distinguishes successful investors from the unsuccessful ones.

AQR concludes the article with this: "Replacing bad habits with good practices is not easy. Habits are behavioral routines that tend to occur unconsciously, so the first step toward change is identifying them."

You now are informed about some of investors' most common bad behaviors. Hopefully, since correcting bad habits can lead to a dramatic improvements in returns, this will provide sufficient motivation to change if you've been guilty of bad behavior.