How to Stop Your Instincts and Biases From Ruining Your Portfolio Returns

In the latest episode of Real Personal Finance, Scott Frank, founder of Stone Steps Financial, and Meg Bartelt, founder of Flow Financial Planning, LLC dive into the fascinating world of investment psychology, addressing how cognitive biases can impede sound financial decision-making. The episode, titled "How to Stop Your Instincts and Biases From Ruining Your Portfolio Returns," serves as a comprehensive guide for investors trying to navigate the psychological minefield that often comes with managing investments.

There can be a significant impact of cognitive biases, particularly recency bias, on investment decisions. Recency bias is the tendency to overemphasize recent events when making decisions about the future. This bias can lead investors to make suboptimal choices, such as holding onto high-performing stocks for too long or selling off underperforming ones prematurely. Scott and Meg illustrate this point by discussing the recent performance of big tech stocks, which have seen a meteoric rise. This surge has distorted some investors' attitudes, making them reluctant to part with these stocks despite the risk of overvaluation.

The episode also explores the importance of having a well-defined investment philosophy. Scott and Meg implore investors that having a structured approach to investing can help mitigate the effects of cognitive biases. They liken this to modern eating habits, where our instincts to consume as much as possible are at odds with the abundance of food available. Similarly, our instincts in the stock market can lead us astray unless we have a structured system to guide our decisions. Addressing these cognitive pitfalls is crucial for maintaining a healthy investment strategy.

In addition to discussing cognitive biases, Scott and Meg delve into the essentials of investing across various markets. They stress the critical role of the risk-free rate in decision-making. This rate, often represented by U.S. Treasury bonds, serves as a benchmark for the minimum return an investor should expect. It is also essential that investors understand why past performance is not a reliable predictor of future success. Scott and Meg explain that while large U.S. companies have historically returned about 10% per year and smaller companies around 12%, these averages do not guarantee future returns. The key is to maintain a balanced portfolio and avoid the temptation to chase recent successes.

Scott introduces the concept of tolerance bands as a strategy for managing investments. Tolerance bands are predefined thresholds that dictate when to buy or sell assets in a portfolio. For example, if an investor allocates 10% of their portfolio to U.S. stocks, a tolerance band of 20% would allow this allocation to fluctuate between 8% and 12%. When the allocation exceeds these limits, the investor would sell high-performing assets and buy underperforming ones, adhering to the principle of "buy low, sell high." This approach helps mitigate emotional decision-making and promotes long-term financial success.

This is one strategy for  rebalancing, which is the process of realigning the proportions of assets in a portfolio to maintain the desired allocation. Meg likens this to a thermostat that maintains a comfortable temperature by activating the heater or air conditioner only when necessary. Similarly, rebalancing helps investors avoid constant adjustments and minimizes transaction costs and tax consequences.

Another key point is the global diversification of investments. While the U.S. stock market has outperformed international markets in recent years, Scott and Meg caution against putting all your eggs in one basket. They explain that the U.S. stock market makes up about 61% of the global market, but other regions, including developed and emerging markets, offer significant opportunities. By diversifying across different markets, investors can reduce risk and increase the potential for higher returns.

But how do investors keep their emotions from running their portfolios? Scott and Meg recommend creating a set of investment rules and writing them down. These rules, based on academic research and professional insights, act as a safeguard against cognitive biases. For instance, having a rule to rebalance the portfolio annually can help investors stick to their strategy even during volatile market conditions.

This episode of Real Personal Finance provides a wealth of information for investors looking to build a resilient portfolio. By understanding and mitigating cognitive biases, maintaining a balanced portfolio, and diversifying across global markets, investors can achieve long-term financial success.

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Scott Frank on LinkedIn 

Meg Bartelt on LinkedIn 

Stone Steps Financial 

Money can be confusing—but it doesn’t have to be. When you’re able to understand the complexities, you can make better decisions to improve your daily life. Are you ready to align your money with your ideal life? Connect with us at Stone Steps Financial.