Financial Opinion and Insights

Investor Behavior Influenced by Bias

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen, CFP®, AIF®

In a study titled “Risk Aversion or Myopia? Choices in Repeated Gambles and Retirement Investments,” Shlomo Benartzi and Richard Thaler, professors at the Anderson School at UCLA and the University of Chicago, respectively, studied a group of defined contribution plan participants.  The participants were divided into two groups and each group was told they could choose between only two funds, A and B.  They were then given some information about the historical returns of these funds and were asked to decide, based on this information, how much of their retirement money they would invest in each fund.  The returns for the funds were derived from actual stock and bond returns.  The manipulation in the experiment was the manner in which the fund returns were displayed.

One group was shown a distribution of one-year returns for both stocks and bonds.  The other group was shown a distribution of 30-year returns.  The academics predicted that subjects viewing the one-year chart would invest less in stocks than subjects viewing the 30-year return chart.  They based their forecast on the fact that the one-year chart accentuated the perceived risk of investing in stocks.  They stated that over a one-year period, the likelihood of stocks underperforming bonds is about a third, while over a 30-year period the likelihood is about 5%.

The results found that the group looking at the distribution of one-year returns allocated their portfolios much more conservatively: 60% to bonds and 40% to stocks.  In contrast, the group that saw the 30-year return distribution allocated their portfolios more aggressively: 10% to bonds and 90% to stocks.  Exposure to frequency of returns tends to affect an investor’s tolerance for risk.

Source: Shlomo Benartzi and Richard H. Thaler, “Risk Aversion or Myopia? Choices in Repeated Gambles and Retirement Investments,” Management Science, March 1999, Vol. 45, No. 3, pp. 364–381. The returns for the funds were derived from the CRSP (Center for Research in Security Prices, Booth School of Business, The University of Chicago) value-weighted NYSE index for stocks and Ibbotson’s annual returns on five-year government bonds.

Bias can lead to regret.

One major bias of individual investors is `recency’ bias; this happens when an investor attaches greater importance to one event than another simply because it occurred more recently.  This bias often leads to regret, which can take many forms. 

Consider the situation of each of the following investors. Investor A purchased shares in Company ABC on Jan. 1, 2007. This investor consequently sold the shares at the end of June because of the flat performance of the company. Investor B considered purchasing shares in Company ABC on the same day Investor A sold his shares, but after much consideration decided to take a pass. As the chart illustrates, Company ABC performed extremely well from July 2007 through November 2008 (although afterward it did slump a bit). Which investor is unhappier as a result of their decision?

Logically, the economic outcome is the same and therefore both investors should have the same amount of regret. However, studies have shown that the regret of having done something (commission) is greater than the regret of not having done anything (omission). Therefore, Investor A experiences more regret than Investor B.

In an unpublished study by two prominent academics in the field of behavioral finance, Daniel Kahneman and Richard Thaler, 100 wealthy investors were asked to bring to mind the financial decision they regretted most.  The majority of participants reported their greatest regret was from something that they had done.  Those who reported a regret of not having done something were shown to take on more risk.  They generally held an unusually high proportion of their portfolio in stocks.  In summary, people who regret the opportunities they missed tend to take more risks than people who regret attempts that failed.

The stock illustrated in this example was selected from Morningstar’s database of publicly traded equities.

It’s little wonder that the long-term investors using a plan tend to outperform those who think they can succeed without one.


Our thanks to Morningstar for their aid in the preparationof this post.


Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.