The ABCs of Behavioral Biases
Evidence-Based Behavioral Finance
But don't take our word for it. Just as we turn to robust academic evidence to guide our disciplined investment strategy, so too do we turn to the work of behavioral finance scholars, to understand and employ effective defenses against your most aggressive behavioral biases.
If there weren't so much damage done, behavioral finance might be of merely academic interest. But given how often - and in how many ways - your fight-or-flight instincts collide with your rational investment plans, it's worth being aware of the tell-tale signs, so you can detect when a behavioral bias may be running roughshod over your higher reasoning. To help with that, here's a summary of the biases we've covered throughout this series:
The Damage Done
Going down with the proverbial shipby fixing on rules of thumb or references that don't serve your best interests.
"I paid $11/share for this stock and now it's only worth $9. I won't sell it until I've broken even."
The mirror might lie after all. We can assess others' behavioral biases, but we often remain blind to our own.
"We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are." (Daniel Kahneman)
This "I thought so" bias causes you to seek news that supports your beliefs and ignore conflicting evidence.
After forming initial reactions, we'll ignore new facts and find false affirmations to justify our chosen course ... even if it would be in our best financial interest to consider a change.
Familiarity breeds complacency. We forget that "familiar" doesn't always means "safer" or "better."
By overconcentrating in familiar assets (domestic vs. foreign, or a company stock) you decrease global diversification and increase your exposure to unnecessary market risks.
Financial fear is that "Get me out, NOW" panic we feel whenever the markets turn brutal.
"We'd never buy a shirt for full price then be O.K. returning it in exchange for the sale price. 'Scary' markets convince people this unequal exchange makes sense." (Carl Richards)
Six of one or half a dozen of another? Different ways of considering the same information can lead to illogically different conclusions.
Narrow framing can trick you into chasing or fleeing individual holdings, instead of managing everything you hold within the greater framework of your total portfolio.
Excitement is an investor's enemy (to paraphrase Warren Buffett.)
You can get burned in high-flying markets if you forget what really counts: managing risks, controlling costs, and sticking to plan.
"If everyone jumped off a bridge ..." Your mother was right. Even if "everyone is doing it," that doesn't mean you should.
Herd mentality intensifies our greedy or fearful financial reactions to the random events that generated the excitement to begin with.
"I knew it all along" (even if you didn't). When your hindsight isn't 20/20, your brain may subtly shift it until it is.
If you trust your "gut" instead of a disciplined investment strategy, you may be hitching your financial future to a skewed view of the past.
No pain is even better than a gain.We humans are hardwired to abhor losing even more than we crave winning.
Loss aversion causes investors to try to dodge bear markets, despite overwhelming evidence that market timing is more likely to increase costs and decrease expected returns.
Not all money is created equal. Mental accounting assigns different values to different dollars - such as inherited assets vs. lottery wins.
Reluctant to sell an inherited holding? Want to blow a windfall as "fun money"? Mental accounting can play against you if you let it overrule your best financial interests.
Luck or skill? Even when an outcome is just random luck, your biased brain still may attribute it to special skills.
If you misattribute good or bad investment outcomes to a foresight you couldn't possibly have had, it imperils your ability to remain an objective investor for the long haul.
A "Lake Wobegon effect," overconfidence creates a statistical impossibility: Everyone thinks they're above average.
Overconfidence puffs up your belief that you've got the rare luck or skill required to
consistently "beat" the market, instead of patiently participating in its long-term returns.
Looks can deceive. Our survival instincts strongly bias us toward finding predictive patterns, even in a random series.
By being predisposed to mistake random market runs as reliable patterns, investors are often left chasing expensive mirages.
Out of sight, out of mind. We tend to let recent events most heavily influence us, even for our long-range planning.
If you chase or flee the market's most recent returns, you'll end up piling into high-priced hot holdings and selling low during the downturns.
Sunk Cost Fallacy
Throwing good money after bad.It's harder to lose something if you've already invested time, energy or money into it.
Sunk cost fallacy can stop you from selling a holding at a loss, even when it is otherwise the right thing to do for your total portfolio.
Tracking Error Regret
Shoulda, coulda, woulda. Tracking error regret happens when you compare yourself to external standards and wish you were more like them.
It can be deeply damaging to your investment returns if you compare your own performance against apples-to-oranges measures, and then trade in reaction to the mismatched numbers.
Next Steps: Think Slow
Even once you're familiar with the behavioral biases that stand between you and clear-heading thinking, you'll probably still be routinely tempted to react to the fear, greed, doubt, recklessness and similar hot emotions they generate.
Nobel laureate Daniel Kahneman helps us understand why in his book, "Thinking, Fast and Slow," where he describes how we engage in System 1 (fast) and System 2 (slow) thinking: "In the picture that emerges from recent research, the intuitive System 1 is more influential than your experience tells you, and it is the secret author of many of the choices and judgments you make."
In other words, we can't help ourselves. When we think fast, our instincts tend to run the show; for better or worse, they're the first thoughts that come to mind.
This is one reason an objective advisor can be such a critical ally, helping you move past your System 1 thinking into more deliberate decision-making for your long-term goals. (On the flip side, financial providers who are themselves fixated on picking hot stocks or timing the market on your behalf are more likely to exacerbate than alleviate your most dangerous biases.)
Investors of "Ordinary Intelligence"
Berkshire Hathaway Chairman and CEO Warren Buffett is a businessman, not a behavioral economist. But he does have a way with words. We'll wrap with a bit of his timeless wisdom:
"Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."
If you can remember this cool-headed thinking the next time you're tempted to act on your investment instincts, Mr. Buffett's got nothing on you (except perhaps a few billion dollars). But if you could use somes help managing the behavioral biases that are likely lurking in your blind spot, give us a call. In combatting that which you cannot see, two views are better than one.