Your wardrobe reflects your lifestyle — from items that let you suit up for business to clothes for kicking around town, from elegant outfits for formal events to athletic attire for when you’re on the move.
Whatever your fashion sense, you can’t get by with a pair of jeans for every occasion. Likewise, your investment portfolio needs variety to 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 on biases you might not be aware that you have. A dated jacket or a trendy pair of earrings can be weeded out quickly, but a mistake in your investment choices can reverberate into retirement and even beyond.
Let’s take a closer look at some of the biases that can cloud your thinking. Then we’ll examine steps you can consider to help build a personalized portfolio that suits your long-term goals, accounts for your risk tolerance, and meets your liquidity needs, as well.
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 stock.
- 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 with limited earnings.
- Consideration: Again, remember that diversification may potentially help weather market volatility over the long term.
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, it’s hard for investors to ignore 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 your 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: Examine emerging markets, where evidence shows thousands are climbing into the middle class and ready to contribute to growing economies. Sure, investing there comes with risks, but it also comes with potential rewards. 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’s 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, “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 financial team to maintain objectivity, manage risk and stay focused on long-term goals rather than toward short-term financial — 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 the right combination of fixed income, equity holdings, real assets, and alternative investment strategies.
- Actively manage risk. You clean out your closet periodically, right? 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.
- Weave social 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 your advisor to run social screens on your complete portfolio, including investments, charitable trusts, and asset transfers. Then collaborate on any adjustments needed to help the overarching financial 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 and for information on planning for retirement.
All investing involves risk including the possible loss of principal. Foreign investing presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
Diversification does not guarantee profit or protect against loss in declining markets. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.
Alternative investments carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. Available to pre-qualified investors only.
Real estate investments carry a certain degree of risk and may not be suitable for all investors.
This information is provided for educational and illustrative purposes only.