Behavioral biases directly challenge an investor’s ability to make consistent, rational and logical investment decisions when faced with distractions. These distractions come from the media, uncertainty and volatility in the markets, or pressure to buy and sell from friends, relatives, financial “gurus” and other less than reliable sources for investment advice. Being able to identify distractions and put them in context can help investors see beyond their own human nature and act with more discipline when it comes to their portfolio choices.
The study of Behavioral Finance emerged in the early 2000s with groundbreaking research done by Daniel Kahneman, a psychology professor at Princeton University and winner of the 2002 Nobel Prize in Economics. Kahneman’s investigation demonstrated “repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.” These findings suggest that investors will often make decisions based on their emotions rather than using logic and historical data.
Confirmation Bias
The scientific method recommends carefully gathering facts, evaluating them and then coming to a conclusion based on your findings. We like to think that we all follow this method in our decision-making process but, the truth is, we don’t. By nature, people tend to reach a conclusion first and then seek out information that supports the conclusion they already have.
We develop narratives to support our unique concept of reality and, when a conclusion already fits into the narrative we’ve created, it’s comforting. When it comes to investing, confirmation bias can lead you to make portfolio decisions that support your existing investment philosophy or preference for a particular stock by seeking information that serves to perpetuate your beliefs rather than reviewing all of the information available which may or may not discredit your conclusion.
Optimism Bias
Optimism bias, in short, is overconfidence. Case in point, most of us think we are better drivers than we actually are. A poll asked drivers what they thought of themselves behind the wheel and 80% of drivers said their driving skills are above average. Anyone driving on the highway would likely disagree with this statement.
When it comes to investing, a great many investors believe they make better decisions than they actually do. Optimism bias can also lead us to be more hopeful about investments than we should be. According to a State Street Center for Applied Research study conducted in 2012, two thirds of investors rated their financial acumen as advanced. When investors took a financial literacy exam the average score was only 61% which, in school, would have given test-takers an average grade of D in financial sophistication.
Loss Aversion
Put simply, we dislike losing a whole lot more than we like winning. In an investment setting this can lead you to make choices that are too cautious to satisfy your long-term goals. An unreasonable aversion to risk coupled with unjustified optimism causes many investors to make grand forecasts but timid choices. From a long-term investment standpoint, loss aversion bias is troubling. Investors need to assume a certain level of risk to grow their portfolio to meet their needs after they retire; for those who lack the tolerance to assume enough risk, the rate of their portfolio’s growth may not outpace inflation, let alone fund 20 or 30 years of retirement.
Recency Bias
As we move through the world we rely on habits to create structure and order in our lives. One could say that we have a habit of forming habits. This is recency bias. Habits work great for a lot of things when it comes to daily life. When it comes to investing, however, this type of behavior can trick us into making decisions we may not have made otherwise.
We are hard-wired to use our recent experiences as a benchmark for what might happen next. When the market goes down investors fear that it will continue to do so and they sell off. If they simply looked at a long-term market chart they would see that the likelihood of the market continuing to fall and never climbing back up again is infinitesimally low, historically speaking. But pesky recency bias has our brains thinking only about yesterday and ignoring the prior 10 or 20 years of history.
Stay Focused on Your Goals
Hindsight, as they say, is twenty-twenty. Recognizing behavioral biases before they negatively impact your investment decisions will serve you and your portfolio well. Working with a fiduciary financial advisor to help you define goals and manage your portfolio is one of the most effective ways to manage your behavioral biases. With both personality and money profiling as part of a holistic financial planning program, a financial advisor should work to help each client to better understand the behaviors that can harm investment performance.
Join us for a discovery meeting to discuss your needs and goals in financial planning and wealth management by contacting us at [email protected]. Our team will help you overcome distractions and behavioral biases to execute a long-term plan that fits your goals.
Citation & Sources
Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (Hoboken, NJ: Wiley, 1998)
https://www.forbes.com/sites/peterlazaroff/2016/09/28/confirmation-bias/#3416a1654b7d
https://www.nytimes.com/2016/03/27/your-money/why-we-think-were-better-investors-than-we-are.html?_r=0
http://www.investinganswers.com/financial-dictionary/investing/home-bias-6206
Nathan Novemsky, Daniel Kahneman (2005) The Boundaries of Loss Aversion. Journal of Marketing Research: May 2005, Vol. 42, No. 2, pp. 119-128.
