It’s been well-documented that, on average, retail investors are “dumb” money. For example, on average, the stocks they buy go on to underperform and the stocks they sell go on to outperform. Investors, sadly, even manage to underperform the very mutual funds in which they invest.
Research from the field of behavioral finance has provided explanations for these poor results. In short, they’re the product of a long list of investment “biases” exhibited by individual investors. Among these biases are: Investors lack portfolio diversification due to overconfidence and a preference for investing in familiar securities (a home-country bias); they tend to trade too much (overconfidence again); they are reluctant to realize their losses (it is too painful to admit mistakes); they extrapolate recent superior returns into the future (the hot-hands fallacy); and they have a preference for skewness and lottery-type investments (which is explained by prospect theory).
While studies have shown that individual investors, on average, exhibit investment biases, little research has been devoted to uncovering their origins and the differences in them across investors. This, in turn, raises two questions: Are investors genetically endowed with certain predispositions that manifest themselves as investment biases? Or, do investors exhibit biases as a result of parenting or individual-specific experiences or events?
Investment Biases And Genetics
Henrik Cronqvist and Stephan Siegel contribute to the literature on investment biases with their study, “The Genetics of Investment Biases,” which appeared in the August 2014 issue of the Journal of Financial Economics.
To answer these questions, they used a unique data set, the world’s largest twin registry, the Swedish Twin Registry, and then matched it with detailed data on twins’ investment behaviors. This enabled them to decompose differences across individuals into genetic versus environmental components.
The decomposition was based on an intuitive insight: “Identical twins share 100% of their genes, while the average proportion of shared genes is only 50% for fraternal twins. If identical twins exhibit more similarity with respect to these investment biases than do fraternal twins, then there is evidence that these behaviors are influenced, at least in part, by genetic factors.”
The authors’ database included more than 15,000 sets of twins. Following is a summary of their findings:
- Genetic differences explain up to 45% of the remaining variation across individual investors after controlling for observable individual characteristics.
- Genetic factors that influence investment biases also affect behavior in other, noninvestment domains. For example, the correlation between preferences for familiar stocks and familiarity preferences in other domains is due to shared genetic influences.
Cronqvist and Siegel concluded that their study provided the first direct evidence from real-world, nonexperimental data that persistent investment biases are to a significant extent determined by genetic endowments. It seems that, at least in some cases, we are predestined to make investment mistakes. However, all is not lost.
Genetics Isn’t The Sole Determining Factor
While they found that education level did not moderate the effects of genetics, they also found that among investors with work experience in finance, there was a significant reduction of the relative amount of genetic variation (this was consistent with practical experience in finance moderating genetic predispositions).
They also found that even genetically identical investors who grew up in the same family environment differ substantially in terms of their investment behaviors. Individual-specific environments, experiences or events must therefore play an important role in shaping individuals’ investment behaviors.
The “good” news for many investors is that, at least now when they make a mistake, they can blame in on their genes! But being aware of our own biases gives us the knowledge we need to help us avoid making behavioral errors.
Some ways to do that are to create a well-thought-out investment plan (including an investment policy statement); use only passively managed funds; and, like Odysseus, who knew he couldn’t resist the sirens’ call, tie yourself to the “mast” of a rebalancing table.
This commentary originally appeared February 21 on ETF.com
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