Monday, August 23, 2010

Behavioral Finance for Gen Y: Part 2

I'm back at college for senior year and beginning to think of more and more investing biases that are particularly prevalent among Gen Y - and what you can do to avoid them!

Last week, I highlighted the self-serving bias, where we tend to give ourselves credit for having investing skills when a stock pick goes up, but avoid responsibility for buying it and instead blame bad luck when it goes down. Today, I'm going to highlight risk aversion. Basically, risk aversion is exactly what the term implies: When an investor is given the choice between a risky investment (growth stock) or a less-risky choice (domestic stock index fund), he/she will choose the less risky investment. This is very normal behavior for some people who simply do not recognize the fact that high risk investments can mean high reward, when the possibility for high loss is also understood.

So, if I advocate index funds, why am I highlighting risk aversion here as an investing bias? Ultimately, as Gen Y's, we have a longer investment horizon than Baby Boomers and Gen Xers. As a result, while a balanced allocation of index funds (60%+ of total asset allocation) is ideal, it's rational to own a diversified portfolio of dividend-paying stocks as part of the rest of the allocation, keeping in mind that the individual stock exposure should always be less than the total index fund exposure. With this approach, any bumps from purely buying risky investments (which will lead to risk aversion tendencies should they go down) will be mitigated by the large allocation to index funds. Even better, a diversified basket of stocks in different industries will be less correlated to each other, further lessening risk.

We are lucky in that our time horizon enables us to recover from any particularly poor-performing investment. However, if we diversify well enough and invest in companies that have a long-term history of paying a consistent dividend, the issues that arise because of risk aversion become smaller as the companies we are buying aren't as risky as some of their counterparts. Then, the benefits of this approach are especially notable because of the potential for higher returns in the individual stocks we own, provided we reinvest their dividends. Couple this fact along with the fact that we own a nice portfolio of index funds, and Generation WI$E will be all set.

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