In 2010, the SEC’s Office of Investor Education and Advocacy asked the Library of Congress’s Federal Research Division to prepare a report on behavioral traits of U.S. investors (Report).  We are issuing this Investor Bulletin to remind investors about the Report’s findings and highlight the investing behaviors identified in the study that can undermine investment performance.

The Report presents the findings of the Library of Congress as author, based on research and analysis adhering to accepted standards of scholarly objectivity.  The findings do not necessarily reflect the views of the SEC, its Commissioners, or other members of the SEC’s staff.

What investing behaviors undermine investment performance?

The Library of Congress report identifies nine investing behaviors that can undermine investment performance.  These behaviors include: active trading; the disposition effect; focusing on past performance and ignoring fees; familiarity bias; manias and panics; momentum investing; naïve diversification; noise trading; and inadequate diversification.

• Active Trading:  An investor using an active trading investment strategy engages in regular, ongoing buying and selling of investments.  This kind of investor purchases investments and continuously monitors their activities in order to take advantage of profitable conditions in the market.  The Report concludes that active trading generally results in the underperformance of an investor’s portfolio.

• Disposition Effect:  The disposition effect is the tendency of an investor to hold on to losing investments too long and sell winning investments too soon.  In the months following the sale of winning investments, these investments often continue to outperform the losing investments still held in the investor’s portfolio.

• Focusing on Past Performance of Mutual Funds and Ignoring Fees:  When deciding to purchase shares in a mutual fund, the Report indicates that some investors focus primarily on the mutual fund’s past annualized returns and tend to disregard the fund’s expense ratios, transaction costs, and load fees, despite the harm these costs and fees can do to their investment returns.

• Familiarity Bias:  Familiarity bias refers to the tendency of an investor to favor investments from the investor’s own country, region, state or company.  Familiarity bias also includes an investor’s preference for “glamour investments;” that is, well-known and/or popular investments.  Familiarity bias may cause an investor’s portfolio to be inadequately diversified, which can increase the portfolio’s risk exposure.

• Manias and Panics:  Financial “mania” or a “bubble” is the rapid rise in the price of an investment, reflecting a high degree of collective enthusiasm or exuberance regarding the investment’s prospects.  This rapid rise is usually followed by a contraction in the investment’s price.  The contraction, or “panic” occurs when there is wide-scale selling of the investment that causes a sharp decline in the investment’s price.

• Momentum Investing:  An investor using a momentum investing strategy seeks to capitalize on the continuance of existing trends in the market.  A momentum investor believes that large increases in the price of an investment will be followed by additional gains and vice versa for declining values.

• Naïve Diversification:  Naïve diversification occurs when an investor, given a number of investment options, chooses to invest equally in all of these options.  While this strategy may not necessarily result in diminished performance, it may increase the risk exposure of an investor’s portfolio depending upon the risk level of each investment option.

• Noise Trading:  Noise trading occurs when an investor makes a decision to buy or sell an investment without the use of fundamental data (that is, economic, financial, and other qualitative or quantitative data that can affect the value of the investment).  Noise traders generally have poor timing, follow trends, and overreact to good and bad news in the market.

• Inadequate Diversification:  Inadequate diversification occurs when an investor’s portfolio is too concentrated in a particular type of investment.  Inadequate diversification increases the risk exposure of an investor’s portfolio.

RELATED INFORMATION

• Library of Congress Report and Annotated Bibliography on Investor Behavior.

• For additional information on saving and investing, please see our publication Saving and Investing: A Roadmap to Your Financial Security Through Saving and Investing (also available in Spanish).  For information on questions you should ask when considering an investment, see Ask Questions: Questions You Should Ask About Your Investments (also available in Spanish).

We offer educational materials so that investors can develop an understanding of the securities industry and learn how to avoid costly mistakes and fraud.  Our educational materials also provide tips on how investors can invest wisely.  Investors can order our free publications by calling (800) SEC-0330, or access them on the Internet through the SEC’s Investor.gov website.  For additional educational information for investors, see the SEC’s Investor.gov website or the Office of Investor Education and Advocacy’s homepage.