Breaking Bad Behaviors

Understanding Investing Biases and How to Overcome Them

iShares Market Perspectives | February 2013
i S H A R E S MA R K E T P E R S P E C T I V E S [ 2 ]
Nelli Oster, PhD
Investment Strategist,
BlackRock Multi-Asset
Strategies Group
Russ Koesterich,
Managing Director,
iShares Chief
Investment Strategist
Finance experts have long assumed that investors are
rational, able to process information efciently, evaluate
investment options in an unbiased fashion, and seek to
maximize prots while minimizing risks. The reality is often
more complex, however. In fact, investors routinely make a
series of fundamental missteps. Common ones include:
holding too much cash for too long;
not being sufciently diversied;
trading too frequently;
buying familiar or attention-grabbing assets; and
being reluctant to realize losses even if tax advantageous.
What are the consequences of these mistakes? To cite just one example, an extreme fear
of losses and an undue focus on the short-term performance of an individual asset may
deter an investor from investing in risky assets at all. The costs can be substantial:
adjusted for ination, the return on cash left in a bank account was negative for 2012. In
comparison, world equity markets as measured by the MSCI All Country World Index
returned 13.4% in US dollar terms during the same period. The performance difference
is even greater over time: while an investor would have by the end of 2012 almost
doubled his initial investment made in the world stock markets during the lows of March
2009, a $100 investment made 10 years earlier would have also grown to $178, and 25
years earlier to $340. And this is in addition to any dividends that an investor would have
received during his investment period.
1
Recent years have seen a proliferation in behavioral nance research, which incorpo-
rates insights from psychology about how people actually make decisions and ways in
which they tend to deviate from full rationality. We think that an understanding of these
biases can help investors avoid some common pitfalls and position their portfolios to
better suit their investment needs, enhancing long-term investment performance. This
paper takes a look at whats behind the common mistakes investors make, what those
mistakes are, and potential solutions to mitigate the impact of these biases on portfolio
performance. Those solutions include:
broadening the concept of invested wealth beyond stock market investments;
lengthening the investment horizon to increase comfort around investing in risky assets;
increasing portfolio diversifcation by investing in well-diversifed index funds, ETFs or
lifestyle or target date funds; and
rebalancing periodically with a rules-based or systematic investment approach to
help mitigate investor inertia and biases.
Executive Summary
1
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a
recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee
that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every
material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications
or other transactions costs, which may signicantly affect the economic consequences of a given strategy.
i S H A R E S MA R K E T P E R S P E C T I V E S [ 3 ]
Why We Do the Things We Do: Common Biases
Logic: The art of thinking and reasoning in strict accordance with
the limitations and incapacities of the human misunderstanding.
Ambrose Bierce
While most economic and nance literature assumes that
investors behave rationally and seek to maximize prots and
minimize risks, evidence from psychology suggests otherwise. In
real life, the way people come up with their beliefs and how they
behave is often a lot messier, confounded by mental limitations to
processing all available information, limited willpower, and
emotional and social considerations.
For example, presented with a wealth of options to choose from
and an abundance of information about these options, people
may feel overwhelmed and ultimately not act, refusing to choose
at all. The eld of behavioral nance focuses on understanding
the impact of actual observed human beliefs and preferences on
investment decisions. What follows are some of the cognitive
errors and preferences that have been shown to deter individuals
from making sound investment decisions.
Keeping it simpletoo simple. To deal with the complex world
around us, people often rely on simplifying rules of thumb,
sometimes referred to as heuristics, in forming their beliefs and
making decisions. For example, when assessing the likelihood of
an event occurring, people naturally tend to focus on factors such
as how frequently they have observed it already, or how easy it is
for them to recall it. For example, people tend to put too much
weight on or overreact to information that is recent or otherwise
easily recalled, salient and colorful, while ignoring equally
important evidence that happens to be mundane, boring or
foreign in nature. Advertisers have long used frequent repetition
to make an audience more likely to believe their statements.
Similarly, people often think that small samples should resemble
in their essential characteristics the larger population from which
they are drawn, an effect known as representativeness.
When it comes to investing, this tendency to rely on the simpler
rule of thumb in understanding complex concepts can lead
individuals astray. For example, to simplify matters, or perhaps to
impose self-control over spending, some households divide their
savings into separate accounts for retirement, college, vacation
and other needs. This is known as mental accounting. While this
may seem benign, it can reduce the benets from pooling
investments and diversifying their risks. Nave or insufcient
diversication may also arise from the allocation of savings
equally across chosen assets, known as the 1/n rule. When
applied to retirement plan funds, for example, this rule has the
undesirable characteristic of making the outcome dependent on
plan design details that should be irrelevant for evaluating future
investment performance, such as the number of funds available,
or the number of bond versus stock funds offered. Retirement
plan design may be especially important for less sophisticated
investors, who may perceive the offering of a fund as an implicit
recommendation by the plans sponsor.
2
Seeing the glass half full. People tend to be optimistic and think
that they are correct more often than is the case. And they often
overestimate their own ability to do well in assigned tasks,
especially when important to them personally. For example, in
one study, 93% of American and 69% of Swedish students
thought that they were more skillful than the median driver.
5
And
in another study, 81% of entrepreneurs thought that they had a
good chance of success, yet less than 40% thought that any
business like theirs did.
6

2
Benartzi, S. and Thaler, R. H. (2001) Naive Diversication Strategies in Dened
Contribution Saving Plans, American Economic Review, Vol. 91, Issue 1, 79-98.
3
Tversky, A. and Kahneman, D. (1983) Extensional versus Intuitive Reasoning: The
Conjunction Fallacy in Probability Judgment, Psychological Review, 90, 293-315.
4
Kahneman, D. and Tversky, A. (1972) Subjective Probability: A Judgment of
Representativeness, Cognitive Psychology, 3, 430-454.
5
Svenson, O. (February 1981) Are we all less risky and more skillful than our
fellow drivers? Acta Psychologica, 47 (2), 143-148.
6
Cooper, A.C., Woo, C.Y. and Dunkelberg, W.C. (1988) Entrepreneurs perceived
chances for success, Journal of Business Venturing, 3(2), 97-108.
TEST YOUR BIAS
Example 1:
Linda is 31 years old, single, outspoken and very bright. She
majored in philosophy. As a student, she was deeply concerned
with issues of discrimination and social justice, and also
participated in anti-nuclear demonstrations.
Choose the option that is more likely:
(a) Linda is a bank teller.
(b) Linda is a bank teller and is active in the feminist movement.
Tversky and Kahneman
3
found that 85% of respondents chose
(b) over (a), presumably paying more attention to Lindas
characteristics that were easily available for mental processing
and representative of a feministhowever, since feminist bank
tellers are a subset of bank tellers, the latter are at least as likely
as the former.
Example 2:
Please rank the following in their order of likelihood, where H
depicts heads and T tails in a coin toss:
(a) H-T-H-T-T-H
(b) H-H-H-T-T-T
(c) H-H-H-H-T-H
According to Kahneman and Tversky
4
people tend to think that (a)
is more likely than (b) or (c) as the latter do not appear random; in
reality all three sequences are equally likely for an unbiased coin.
This is an example of representativeness, the expectation that
even small samples should represent the essential characteristics
of the process that was used to generate them, and may lead
people to believe that (b) and (c) were produced by biased coins.
i S H A R E S MA R K E T P E R S P E C T I V E S [ 4 ]
Moreover, the more condent a person is in his own knowledge
or abilities, the more likely he is to downplay information that
contradicts his own. In the investment world, investors may also
attribute positive performance to their own skill but losses to
bad luck, leading to overcondence (until he or she eventually
becomes discouraged).
7
Not seeing the big picture. Another way in which people differ
from the fully rational and self-interested homo economicus is
by not taking into account their entire wealth with asset-specic
risks diversied away. Instead, people tend to focus on specic
investments in isolation. This is an example of what in the eld
of psychology is known as narrow framing of the context in which
a decision is made or presented.
Myopic view on gains and losses. Individuals are usually much
more sensitive to losses than gains in their portfolios. In fact,
studies have estimated the pain from losses to be roughly twice
as impactful as the joy from gains. As a result, people are usually
risk averse for gains, preferring a sure gain to a gamble with the
same expected value, while happy to take on gambles that may
allow them to avoid a loss. In addition, gains and losses are often
evaluated over a relatively short time horizon that may not be in
sync with the longer horizon over which investment goals are
expected to be achieved. Together, the disproportionate dislike
of losses and mental focus on an inappropriately short horizon
are known as myopic loss aversion
Aversion to ambiguity. People prefer known and quantiable
risks to unknown and ambiguous risks, and usually pick choices
with the fewest unknown factors. Insurance companies are well
aware of loss and ambiguity aversion and frame their marketing
pitches accordingly, making a potential customer imagine large
losses that are caused by someone or something else. A similar
phenomenon commonly occurs when it comes to investing.
Fear of regret. Finally, there is the fear of regret from making poor
choices. In addition to losses, regret may also arise from realizing
gains too early, not choosing another investment instead, or some
other alternative that was initially considered but not selected.
Exposure to potential regret may lead an individual to prefer the
status quo and refuse to take any action at all, e.g., staying out of
the stock market altogether.
The good news is that there is some hope for investors as
learning through experience has been found to mitigate some of
these biases. Cognitive mistakes like those described above tend
to be more common when reliable information is scarceand
uncertainty high.
TEST YOUR BIAS
Example 3:
1) In addition to whatever you own, you have been given $1,000.
Which of the following would you prefer?
(a) 50% chance of getting $1,000
(b) Getting $500 for sure
2) In addition to whatever you own, you have been given $2,000.
Which of the following would you prefer?
(c) 50% chance of losing $1,000
(d) Losing $500 for sure
Kahneman and Tversky
8
found that the majority of their subjects
chose (b) and (c), reecting risk aversion for gains and risk-seeking
behavior for losses. However, (a) and (c) boil down to the same
thing, as do (b) and (d). Since the bonuses of $1,000 and $2,000
were common for the two options in the two questions, people
essentially ignored them in their decision making. Instead of total
wealth, the usual assumption in nance theory, people focused on
changes in their wealth.
TEST YOUR BIAS
Example 4:
There is an urn with 30 red balls and 60 balls that are either black
or yellow, with the exact numbers unknown. One ball will be drawn
from the urn at random.
1) Which of the following would you prefer?
(a) $100 if a red ball is drawn
(b) $100 if a black ball is drawn
2) Which of the following would you prefer?
(c) $100 if a red or a yellow ball is drawn
(d) $100 if a black or a yellow ball is drawn
Slovik and Tversky
9
found that most people prefer (a) to (b) and (d)
to (c). This violates rational decision making under uncertainty.
Choosing (a) over (b) implies that the decision maker believes that
the likelihood of a black ball is less than one third, the probability
of a red ball. Choosing (d) over (c) implies that the decision maker
believes that the probability of a red or a yellow ball is less than two
thirds, the probability of drawing a black or a yellow ball. However,
if the probability of drawing a black ball is less than one third, it
must be the case that the probability of drawing a yellow ball is
more than one third, and the probability of drawing a red or a yellow
ball therefore more than two thirds. Therefore choosing (a) over
(b) and (d) over (c) are incompatible with rationality. This is known
as the Ellsberg paradox, and highlights peoples tendency to avoid
ambiguity, preferring options with the fewest unknown elements.
7
Gervais, S. and Odean, T. (2001) Learning to Be Overcondent, Review of Financial
Studies (Spring 2001) Vol. 14, No.1, pp.1-27.
8
Kahneman, D. and Tversky, A. (1979) Prospect Theory: An Analysis of Decision under
Risk, Econometrica, XLVII (1979), 263-291.
9
Slovic, P. and Tversky, A. (1974) Who accepts Savages axiom? Behavioral Science,
19, 368373.
i S H A R E S MA R K E T P E R S P E C T I V E S [ 5 ]
The Impact of Investor Biases
The investors chief problemand even his worst enemy
is likely to be himself.
Benjamin Graham
The biases described above have a signicant impact on
investors portfolios, particularly with respect to stock market
participation, baseline portfolio allocations and trading behav-
ior. Lets take a look at each of these.
To invest or not to invest: An extreme fear of losses in the near
term may deter an individual from investing in risky assets such
as equities altogether. Yet, while stock prices may be highly
volatile, particularly over the short term, they may still be worth
including in a portfolio, especially if they are not perfectly
correlated with other assets, such as housing, labor income,
and so forth, providing diversication benets. For example,
while the stock market may be down one year, the losses may
be offset by an increase in the investors house price, and vice
versa. As we noted above, it is important to view all of ones
assets as the total portfolio, and when considering investing in
the stock market, evaluate its incremental risk to existing wealth
risks, rather than focusing on each asset in isolation.
Yet many individual investors succumb to narrow framing,
looking at each of their investments in isolation,

which, together
with myopic loss aversion, the extreme avoidance of short-term
losses, helps explain individuals reluctance to invest in risky
assets and the low stock market participation rates.
10
In
addition, myopic loss aversion has shed extra light on the equity
premium puzzle,
11
the nding that the historically high differ-
ence between equity and government bond returns requires
investors to have an anomalously high degree of risk aversion.
So how common is stock market avoidance, and what does it
cost an investor to stay in cash? Based on a detailed and
comprehensive study from Sweden, 62% of all Swedish house-
holds were invested in risky assets in 2002. The estimated return
loss for the 38% of households that did not invest in risky assets
was 4.3% a year. However, most of the non-participating
households were demographically similar to households that
tend to invest cautiously and inefciently. Once accounting for
the fact that most of these households would therefore probably
not have held fully diversied portfolios, the estimated return
loss drops to around 2% a year.
12
The costs of staying out of risky assets can be substantial,
particularly in the current, low-yield environment: adjusted for
ination, the return on cash left in a bank account was negative
for 2012. In comparison, world equity markets as measured by
the MSCI All Country World Index returned 13.4% in US dollar
terms during the same period. The performance difference is
even greater over time: while an investor would have by the end
of 2012 almost doubled his initial investment made in the world
stock markets during the lows of March 2009, a $100 investment
made 10 years earlier would have also grown to $178, and 25
years earlier to $340 by now. And this is in addition to any
dividends that an investors would have received during his
investment period.
Both stock market participation and investment allocation
choices are inuenced by past personal experiences. Swedish
investors increased their portfolio diversifcation after Erics-
sons losses at the bursting of the technology bubble highlighted
the perils of concentrated portfolios. In another study based on
more than 40 years of data, people in the United States who had
experienced high stock market returns throughout their lives
were more willing to take on risk and invest in stocks, whereas
those who had lived through periods of high ination tended to
dislike bonds (without ination protection). Further, the younger
and less experienced an individual, the more impact each years
experience had on his expectations.
13 14
What this may imply is
that people who got burned perhaps not only once but twice in
the past decades stock markets may be more reluctant to put
money to use, especially if they had not beneted from the long
bull market before that.
What may in todays uncertain and volatile macroeconomic
environment compound the impact of myopic loss aversion and
adverse personal experiences on stock market (non-)participation
is aversion to ambiguity. With the worlds stock markets increas-
ingly driven by politics and policy makers actions and expecta-
tions thereof, investing has become much more of an art than hard
science. In addition, recent natural disasters such as the earth-
quake in Japan or Hurricane Sandy are still salient in many
peoples memories, and those risks are extremely hard to quantify.
Other factors that may deter individuals from investing in the
stock market include inertia and confusion around too many
choices. For example, despite the attractiveness of dened
contribution plans for saving, with contributions tax deductible,
accumulations growing tax deferred and many companies
matching their employees contributions, retirement plan
10
Barberis, N., Huang, M. and Thaler, R. (2006) Individual Preferences, Monetary
Gambles, and Stock Market Participation: A Case for Narrow Framing, American
Economic Review, 96, 1069-1090.
11
Benartzi, S. and Thaler, R. H. (1995) Myopic Loss Aversion and the Equity Premium
Puzzle, Quarterly Journal of Economics, CX, 73-92.
12
Calvet, L. E., Campbell, J. Y. and Sodini, P. (2007) Down or out: Assessing the welfare
costs of household investment mistakes, Journal of Political Economy, 115, 707-747.
13
Nagel, S. and Malmendier, U. (February 2011) Depression Babies: Do Macroeconomic
Experiences Affect Risk-Taking? Quarterly Journal of Economics, 126(1), 373-416.
14
Nagel, S. and Malmendier, U. (2012) Learning from Ination Experiences, Working Paper.
i S H A R E S MA R K E T P E R S P E C T I V E S [ 6 ]
enrollment rates in both the United States and the United
Kingdom have been surprisingly low. When automatic enrollment
simplied the enrollment process, participation rates increased
substantially. In the same vein, with contribution rates typically
quite low, anchored on the default options or determined by
some other rule of thumb such as maximizing company matching
contributions, the savings observed in 401(k) accounts have
usually been insufcient to cover retirement needs.
15
While typically the more choices an individual is offered the
better off he should be, in reality too many choices can become
paralyzing. Consumers can become overwhelmed and delay
their decisionor ultimately not choose at all. For example, one
study highlighted that people were found to be more likely to buy
gourmet jams when offered a more limited assortment, and
turned out to be more satised ex post.
16
Similarly, participation
rates have been found to be lower in 401(k) plans that offer 10 or
more fund options.
17
A word for any retirement plan sponsors:
the wider the range of potential investments, the more people
may feel that they are exposing themselves to regret from
unsuccessful choices, and the more likely they may be to freeze
in their tracks and not invest at all.
Portfolio choice: When individual investors do take the plunge,
they often apply nave rules of thumb that result in holding
familiar assets in concentrated portfolios. An example is the
so-called 1/n rule, where an investor divides his retirement
assets evenly among the funds his or her employer offers as
401(k) plan options. While the 1/n rule may yield a relatively
well-diversied portfolio, it may not correspond well to an
investors personal risk tolerance. For example, while a concen-
tration in stock funds may be reasonable for someone young, for
a worker close to retirement age this would often be deemed too
risky of an allocation.
18
Perhaps thanks to a bloated belief in ones investing abilities,
many individual investors are underdiversied. In a 1991 to 1996
study of the customers of a large US discount brokerage, more
than 25% held only one stock, and more than 50% held three or
fewer stocks. However, a well-diversied portfolio should
include at least 10 to 15 stocks, which only 5% to 10% of the
investors held in any given period. And generally speaking, the
more diversied portfolios performed better: the most diversi-
ed investor group earned more than 2% a year higher returns
than the least diversied group. Demographically, the young,
those with lower incomes, and workers in non-professional
categories tended to hold the least diversied portfolios.
19

Furthermore, in evaluating potential investments, individuals
tend to go with familiar names that they can recall easily,
focusing on their home markets. In an early study on the topic,
domestic equity as a percentage of overall equity was found to
be 94% for US, 98% for Japanese and 82% for British
investors.
20
This is known as the home country bias, and even
presumably more sophisticated investors can suffer from it.
A 2011 study of endowments by the National Association of
College and University Business Ofcers showed that colleges
and universities (especially those with smaller endowments)
still tend to have a persistent overweight in US equities,
although this overweight has gone down over time.
Underdiversication may also arise from a concentrated
position in the stock of an employees rm. It has been estimat-
ed that 11 million Americans have invested more than 20% of
their retirement savings in their company stock, and ve million
more than 60%.
21
While there may be additional sweeteners for
owning ones company stock, this effectively amounts to
anti-hedging of what is for most their main source of income,
employment. The relative value of holding a single stock as
opposed to a diversied portfolio has been shown to be inversely
related to the fraction of wealth in the stock, the investment
horizon and the stocks volatility. For example, allocating 50% of
total wealth to a well-diversied pension plan, and 50% of the
pension plan investments, i.e., 25% of total wealth, to company
stock has been estimated to decrease the risk-adjusted value of
the portfolio by more than one half over a horizon of 15 years.
22

15
Benartzi, S. and Thaler, R. H. (Summer 2007) Heuristics and Biases in Retirement
Savings Behavior, Journal of Economic Perspectives.
16
Iyengar, S. S. and Lepper, M. R. (December 2000) When choice is demotivating: Can
one desire too much of a good thing? Journal of Personality and Social Psychology,
Vol. 79(6), 995-1006.
17
Sethi-Iyengar, S., Huberman, G., and Jiang, W. (2004) How Much Choice is Too Much?
Contributions to 401(k) Retirement Plans, In Mitchell, O.S. and Utkus, S. (Eds.) Pension
Design and Structure: New Lessons from Behavioral Finance, 83-95, Oxford: Oxford
University Press.
18
Benartzi, S. and Thaler, R. H. (2001) Naive Diversication Strategies in Dened
Contribution Saving Plans, American Economic Review, Vol. 91, Issue 1, 79-98.
19
Goetzmann, W. N. and Kumar, A. (2008) Equity Portfolio Diversication, Review of
Finance, Vol. 12, No. 3, 433-463.
20
French, K. and Poterba, J. (1991) Investor Diversication and International Equity
Markets, American Economic Review, 81 (2), 222-226.
21
Mitchell, S. O. and Utkus, S. P. (2004) The Role of Company Stock in Dened
Contribution Plans, In Olivia Mitchell and Kent Smetters (Eds.) The Pension Challenge:
Risk Transfers and Retirement Income Security, 33-70,Oxford: Oxford University Press.
22
Meulbroek, L. (March 2002) Company Stock in Pension Plans: How Costly Is It?
Working Paper No. 02-058, Harvard Business School, Cambridge, MA.
Perhaps thanks to a bloated
belief in ones investing abilities,
many individual investors are
underdiversied.
i S H A R E S MA R K E T P E R S P E C T I V E S [ 7 ]
Trading: Generally speaking, individual investors tend to
move in and out of positions in an inefcient way, reducing
their potential prots.
First, individual investors are often overly condent in their
own abilities to beat the market, trading excessively and hurting
portfolio performance. In one study, customers of a large
discount brokerage house who traded the most earned an
average annual net portfolio return of 11.4% between 1991
and 1996, versus the market return of 17.9%.
23
In another study,
investors who switched from phone to online trading in the
1990s tended to trade more actively than before, and while they
initially beat the market by 2%, after the switch they ended up
lagging the market by 3% a year.
24
Interestingly, men have been
found to be particularly condent in their own skills and trade on
average almost 50% more than women, underperforming
women by 0.94% a year.
25

Individual investors often extrapolate past returns, buying
assets whose prices have gone up. Just as investors gravitate
toward companies that have featured prominently in the news,
good performance tends to grab attention.
26
Investors may also
expect high stock returns to be followed by high returns and low
by low. In one study, employees of rms whose stocks had done
the best in the previous 10 years invested almost 40% of their
discretionary contributions to 401(k) plans in their company
stock, versus about 10% for the worst performing companies.
Yet the extreme allocations did not predict future stock re-
turns.
27
More generally, if not justied by fundamentals, price
increases actually indicate that assets have become more
expensive, foreboding potential reversal and lower expected
returns in the future.
When selling stocks, individual investors tend to be more likely
to get rid of stocks that have done well in the past and keep
losers, avoiding the mental pain associated with realizing losses
and being able to continue their denial. This is known as the
disposition effect, and is particularly striking as tax consider-
ations would lead to the exact opposite conclusion, selling losers
to exploit capital losses and deferring taxable gains. Moreover,
according to a study on the customers of a large national
discount brokerage, the winners that were sold actually contin-
ued outperforming the losers that were held. By selling the loser
rather than the winner an individual could have increased his net
returns by an estimated 4.4% the following year net of taxes.
28

Potential Solutions
Those who are unwilling to invest in the future havent earned one.
H.W. Lewis
With investors averse to losses and ambiguity, and the last
decades two bear markets and hard-to-predict events such as
overthrown governments in the Middle East and natural
disasters still fresh in mind, it is not hard to understand why
many are apprehensive about the risks involved in investing in
stocks and instead choose to stay in cash. This may be a
mistake. First, while cash may seem like a riskless investment,
it is only so in nominal terms. Prices are slowly creeping up,
eroding consumers purchasing power. The current US ination
rate of 1.8% translates to a price increase of 50% in about two
decades, decreasing purchasing power by a third.
Second, while a belief in another potential recession may
justify staying out of equities for a period of time, market timing
is extremely difcult, with gains often accumulating unpredict-
ably, and concentrated on a few trading days. For example, if
an investor had missed just the rst 20% of the market
recovery in 2003, he or she would have underperformed those
who stayed invested throughout the downturn and recovery by
nearly 10%, assuming an investment period from March 2000
to February 2006.
Here are three steps to take that can mitigate the impact of
behavioral biases and non-standard preferences on long-term
investment performance:
Take the plunge: While loss aversion may be a well-document-
ed and persistent human trait, its impact on investment choice
and performance only really becomes detrimental when
combined with the habit of narrow framing
29
. To consciously
tackle these biases, we would recommend investors broaden
their concept of invested wealth to include not only stocks and
bonds, but also income-producing assets such as businesses
and real estate, expected future wealth from employment
income, and personal property such as houses, cars and
artwork. While any wealth category may suffer losses in a given
period of time, when assets are not perfectly correlated, other
wealth categories are likely to help offset these losses. Stock
market investments may seem more appealing and less like
isolated gambles when considered in this broader overall
portfolio diversication context.
23
Barber, B. and Odean, T. (April 2000) Trading is Hazardous to Your Wealth: The
Common Stock Investment Performance of Individual Investors, Journal of Finance, Vol.
LV, No. 2, 773-806.
24
Barber, B. and Odean, T. (March 2002) Online Investors: Do the Slow Die First?
Review of Financial Studies, Vol. 15, No. 2, 455-487.
25
Barber, B. and Odean, T. (February 2001) Boys will be Boys: Gender, Overcondence,
and Common Stock Investment, Quarterly Journal of Economics, Vol. 116, No. 1, 261-
292.
26
Barber, B. and Odean, T. (2008) All that Glitters: The Effect of Attention and News
on the Buying Behavior of Individual and Institutional Investors, Review of Financial
Studies, Vol. 21, 2, 785-818.
27
Benartzi, S. (2001) Excessive Extrapolation and the Allocation of 401(k) Accounts to
Company Stock, Journal of Finance, 56.5, 1747-1764.
28
Odean, T. (1998) Are investors reluctant to realize their losses? Journal of Finance,
53.5, 1775-1798.
29
Barberis, N., Huang, M. and Thaler R. (2006) Individual Preferences, Monetary
Gambles, and Stock Market Participation: A Case for Narrow Framing, American
Economic Review 96, 1069-1090.
i S H A R E S MA R K E T P E R S P E C T I V E S [ 8 ]
unnecessary portfolio concentration resulting from the 1/n rule
or home country bias. One way of doing this is by investing in
well-diversifed mutual funds or ETFs. The chosen investment
strategy should also reect the individuals personal risk
tolerance and investment horizon. These targets may be more
easily maintained through market uctuations by investing in
well-diversied managed funds, such as lifestyle funds that
target a specied level of risk, or target date funds where the
risk level is selected based on the number of years left until
retirement, e.g., higher risk, more aggressive portfolios heavily
invested in equities for younger workers.
For example, BlackRock provides ve long-term strategic asset
allocation models with different risk-return objectives. The
moderate risk fund allocations are depicted in Figure 2 and
relative to the average individual investors portfolio choices,
provide a high degree of diversication, with 53% invested in
xed income, 21% in US equities, 20% in international equities
and 5% in non-traditional asset classes, easily implemented
with only 10 already diversifed iShares ETFs.
As individual investors have shown to be particularly prone to
cognitive errors, tactical market positioning around the long-term
allocation may be better left to experienced investment professionals
dedicated to the task. For example, the BlackRock Model Portfolio
Solutions Group offers a series of outcome-oriented and tactical
model portfolios implemented with iShares ETFs and BlackRock
mutual funds to help clients gain access to income or tactical market
views efciently. These models use a rigorous process to manage
portfolio level risks, taking into account not only an assets size but
also its riskiness when deciding its weight in a portfolio, and are
therefore well-positioned to help deliver better long-term risk-ad-
justed returns than simple market capitalization-weighted indices.
We would also advocate that investors position their core
portfolio holdings for the longer term, and only evaluate them
periodically rather than continuously. While stock markets can
be highly volatile over short horizons, increasing investor
discomfort around potential losses, time has tended to smooth
out uctuations. Figure 1 shows the worst returns in annualized
terms over the past 25 years of the MSCI All Country World Index
as a broad global equity market benchmark, the S&P 500 Index
as a broad US equity market benchmark and the Barclays
Capital Aggregate Bond Index as a broad US xed income
benchmark based on different return horizons. For example,
while the worst annualized monthly return of the S&P 500 Index
during the period was -203%, this improved to -45% for annual
returns, -4.1% for 10-year returns and 7.6% for 20-year returns.
Additionally, portfolio construction techniques to minimize
overall fund volatility, possibly packaged into exchange traded
funds such as the iShares MSCI All Country World Minimum
Volatility Index Fund (ACWV), tend to provide downside protec-
tion in volatile markets and may help increase investor comfort
around investing in risky assets.
When it comes to retirement savings, automatic enrollment and
sensible default contribution rates, together with automatic
savings increases at the time of pay increases, have been shown
to effectively counteract investor inertia, loss aversion and
self-control issues, leading to increased participation rates and
savings. The sensitivity of the chosen retirement investment
allocations to the way the options are framed underlines the
importance of overall plan design.
30
Diversify, diversify, diversify: We advocate that investors
implement a long-term baseline allocation that is diversied
across US and international equities, xed income and non-tra-
ditional asset classes such as commodities, revisiting any
US Fixed Income 31.10%
High Yield 5.00%
International Treasury Bond 7.30%
TIPS 10.00%
US Equities 21.40%
Emerging Markets 5.20%
Developed Markets ex-US 14.70%
Commodity 3.00%
Gold 0.40%
Reits 1.90%
Figure 2: BlackRock Strategic Models - Moderate Allocation

30
Benartzi, S. and Thaler, R. H. (Summer 2007) Heuristics and Biases in Retirement Savings
Behavior, Journal of Economic Perspectives. Source: Bloomberg, as of 12/21/12.
1 month 6 months 12 months 3 month 5 years 3 years 10 years 20 years
MSCI ACWI Barclays Agg S&P 500
-250%
-200%
-150%
-100%
-50%
0%
50%
Figure 1: Worst Annualized Return by Horizon
i S H A R E S MA R K E T P E R S P E C T I V E S [ 9 ]
When picking a nancial advisor or a mutual fund, it helps to be
patient and, if possible, evaluate performance over several years
relative to agreed-upon objectives, rather than extrapolating on
a short history of returns, possibly cutting a fund due to a recent
blip in performance despite its consistent outperformance over
the longer horizon.
Rebalance: To ensure that a portfolios allocations remain in the
target range, we recommend that it be rebalanced on schedule,
e.g., quarterly or semi-annually, or once allocations have moved
away from the target by a predetermined percentage. Some
investors succumb to inertia and forego timely rebalancing,
while others trade excessively, which may lead to any invest-
ment prots getting eaten up by trading costs. When available,
it may be in fact helpful to set up automatic rebalancing,
although any retirement plan options such as the funds avail-
able should still be reviewed periodically.
When investments are actively evaluated and selected, the
focus should be on future expected returns, rather than past
performance. Behavioral biases may be mitigated by a rules-
based or systematic investment approach, such as investment
models built to predict fair asset values, quantitative screens
to sift through investments with ex-ante thresholds to ag
opportunities, or systematic checklists with comprehensive sets
of questions. Many systematic funds in fact attempt to exploit
known market anomalies that have possibly arisen for behavioral
reasons, such as the post-earnings announcement drift (share
prices continuing to drift in the direction of an initial jump after
corporate announcements such as large earnings or dividend
changes), or price momentum (stocks that have outperformed
over a period of six months continuing to outperform for the next
six to twelve months). Stop-loss rules may soften the impact of
individual investors general reluctance to realize losses, leading
to increased selling of losing investments and harvesting of capital
losses to minimize tax burden.
Conclusion
I know you think you understand what you thought I said but Im not
sure you realize that what you heard is not what I meant.
Alan Greenspan
Financial markets operate around the knowledge, perceptions,
judgments and biases of its participants, often backed by messy
real-life decisions made amidst incomplete information and
uncertainty. To better understand actual observed investor
behavior and to help shed light on to market anomalies that have
been difcult to explain under the traditional assumptions of full
rationality and market efciency, behavioral nance incorporates
insights from human psychology. In the real world, people are less
than rational, suffer from inertia, have limited cognitive abilities,
focus excessively on the short term with a high degree of aversion
to losses, and are overcondent in their own prospects.
As a result of these biases, individual investors have been
found to shun the stock market, hold excessively concentrated
portfolios of companies they are familiar with, and trade too
much. Certain parts of the population have been found to be
particularly prone to given biases. For example, men tend to
be especially condent in their own abilities and succumb to
portfolio losses from excessive trading. The performance impact
of these biases can be signicant, especially if they result in
portfolio exposures that are ill suited for a given individuals
nancial goals.
Understanding behavioral biases and attempting to mitigate
their impact on investment performance through rules-based
or systematic strategies may be especially important amidst
todays increased economic uncertainty and market volatility.
The ongoing deleveraging in developed markets has raised
overall macroeconomic instability, as seen with higher growth
and ination volatility. This has not been helped by the often
erratic politics and policy making in countries with structural
imbalances and need for reform. While suboptimal investment
choices resulting from cognitive errors may not have mattered
much in a secular bull market such as during the 1990s, today
when companies and entire countries hang on the lifeline of
central banks and other countries angry voters, biases such as
individual investors general reluctance to realize losses may
cause some serious havoc on portfolio performance.
i
S
-
8
9
3
2
-
0
1
1
3
Carefully consider the iShares Funds investment objectives, risk factors, and
charges and expenses before investing. This and other information can be
found in the Funds prospectuses, which may be obtained by calling
1-800-iShares (1-800-474-2737) or by visiting www.iShares.com. Read the
prospectus carefully before investing.
Investing involves risk, including possible loss of principal. Diversication may not
protect against market risk. In addition to the normal risks associated with investing,
international investments may involve risk of capital loss from unfavorable uctuation in
currency values, from differences in generally accepted accounting principles or from
economic or political instability in other nations. The iShares Minimum Volatility Funds may
experience more than minimum volatility as there is no guarantee that the underlying indexs
strategy of seeking to lower volatility will be successful.
Index returns are for illustrative purposes only and do not represent actual iShares Fund
performance. Index performance returns do not reect any management fees,
transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in
an index. Past performance does not guarantee future results. For actual iShares Fund
performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares
(1-800-474-2737).
The iShares Funds that are registered with the US Securities and Exchange Commission under
the Investment Company Act of 1940 (Funds) are distributed in the US by BlackRock
Investments, LLC (together with its afliates, BlackRock). This material is solely for educational
purposes and does not constitute an offer or solicitation to sell or a solicitation of an offer to buy
any shares of any fund (nor shall any such shares be offered or sold to any person) in any
jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities
law of that jurisdiction.
This material is solely for educational purposes and does not constitute an offer or solicitation to
sell or a solicitation of an offer to buy any shares of any fund (nor shall any such shares be offered
or sold to any person) in any jurisdiction in which an offer, solicitation, purchase or sale would be
unlawful under the securities law of that jurisdiction.
In Latin America, for Institutional and Professional Investors Only (Not for public Distribution):
If any funds are mentioned or inferred to in this material, it is possible that some or all of the funds
have not been registered with the securities regulator of Brazil, Chile, Colombia, Mexico, Peru,
Uruguay or any other securities regulator in any Latin American country, and thus might not be
publicly offered within any such country. The securities regulators of such countries have not
conrmed the accuracy of any information contained herein. No information discussed herein can
be provided to the general public in Latin America.
In Hong Kong, this document is issued by BlackRock (Hong Kong) Limited for Institutional
Investors only and has not been reviewed by the Securities and Futures Commission of Hong
Kong. In Singapore this is issued by BlackRock (Singapore) Limited (Co. registration no.
200010143N) for Institutional Investors only.
Notice to residents in Australia:
FOR WHOLESALE CLIENTS AND PROFESSIONAL INVESTORS ONLY NOT FOR
PUBLIC DISTRIBUTION
Issued in Australia by BlackRock Investment Management (Australia) Limited ABN 13 006 165
975, AFSL 230523 (BlackRock). This information is provided for wholesale clients and
professional investors only. Before investing in an iShares exchange traded fund, you should
carefully consider whether such products are appropriate for you, read the applicable prospectus
or product disclosure statement available at iShares.com.au and consult an investment adviser.
Past performance is not a reliable indicator of future performance. Investing involves risk including
loss of principal. No guarantee as to the capital value of investments nor future returns is made
by BlackRock or any company in the BlackRock group. Recipients of this document must not
distribute copies of the document to third parties. This information is indicative, subject to change,
and has been prepared for informational or educational purposes only. No warranty of accuracy
or reliability is given and no responsibility arising in any way for errors or omissions (including
responsibility to any person by reason of negligence) is accepted by BlackRock. No representation
or guarantee whatsoever, express or implied, is made to any person regarding this information.
This information is general in nature and has been prepared without taking into account any
individuals objectives, nancial situation, or needs. You should seek independent professional
legal, nancial, taxation, and/or other professional advice before making an investment decision
regarding the iShares funds. An iShares fund is not sponsored, endorsed, issued, sold or
promoted by the provider of the index which a particular iShares fund seeks to track. No index
provider makes any representation regarding the advisability of investing in the iShares funds.
Notice to investors in New Zealand:
FOR WHOLESALE CLIENTS ONLY NOT FOR PUBLIC DISTRIBUTION
This material is being distributed in New Zealand by BlackRock Investment Management
(Australia) Limited ABN 13 006 165 975, AFSL 230523 (BlackRock). In New Zealand, this
information is provided for registered nancial service providers and other wholesale clients only
in that capacity, and is not provided for New Zealand retail clients as dened under the Financial
Advisers Act 2008. BlackRock does not offer interests in iShares to the public in New Zealand,
and this material does not constitute or relate to such an offer. Before investing in an iShares
exchange traded fund, you should carefully consider whether such products are appropriate for
you, read the applicable prospectus or product disclosure statement available at iShares.com.au
and consult an investment adviser. Past performance is not a reliable indicator of future
performance. Investing involves risk including loss of principal. No guarantee as to the capital
value of investments nor future returns is made by BlackRock or any company in the BlackRock
group. Recipients of this document must not distribute copies of the document to third parties.
This information is indicative, subject to change, and has been prepared for informational or
educational purposes only. No warranty of accuracy or reliability is given and no responsibility
arising in any way for errors or omissions (including responsibility to any person by reason of
negligence) is accepted by BlackRock. No representation or guarantee whatsoever, express or
implied, is made to any person regarding this information. This information is general in nature
and has been prepared without taking into account any individuals objectives, nancial situation,
or needs. You should seek independent professional legal, nancial, taxation, and/or other
professional advice before making an investment decision regarding the iShares funds. An
iShares fund is not sponsored, endorsed, issued, sold or promoted by the provider of the index
which a particular iShares fund seeks to track. No index provider makes any representation
regarding the advisability of investing in the iShares funds.
The strategies discussed are strictly for illustrative and educational purposes and should not be
construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer
to buy any security. There is no guarantee that any strategies discussed will be effective. The
information provided is not intended to be a complete analysis of every material fact respecting
any strategy. The examples presented do not take into consideration commissions, tax
implications or other transactions costs, which may signicantly affect the economic
consequences of a given strategy.
This material represents an assessment of the market environment at a specic time and is not
intended to be a forecast of future events or a guarantee of future results. This information should
not be relied upon by the reader as research or investment advice regarding the funds or any
security in particular.
2013 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered and
unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and
elsewhere. All other marks are the property of their respective owners.
iS-8932-0113 5175-07RB-01/13
Not FDIC Insured No Bank Guarantee May Lose Value
For more information visit www.iShares.com
or call 1-800-474-2737