Our own behavioral biases are often the greatest threat to our financial well-being. As investors, we leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done. In this multi-part series “Behavioral Biases A to Z,” we’ll offer an alphabetic introduction to investors’ most common and damaging behavioral biases.
Behavioral biases trick us into wallowing in what financial author and neurologist William J. Bernstein, MD, PhD, describes as a “Petrie dish of financially pathologic behavior,” including:
• Counterproductive trading – incurring more trading expenses than are necessary, buying when prices are high and selling when they’re low.
• Excessive risk-taking – rejecting the “risk insurance” that global diversification provides, instead over-concentrating in recent winners and abandoning recent losers.
• Favoring emotions over evidence – disregarding decades of evidence-based advice on investment best practices.
Here are a few additional ways you can defend against the behaviorally biased enemy:
Begin with a solid plan – develop a roadmap for your investment activities (with predetermined asset allocations that reflect your personal goals and risk tolerances); you’ll stand a much better chance of overcoming the bias-driven distractions that rock your resolve along the way.
Increase your understanding – Don’t just take our word for it. Here is an entertaining and informative library on the fascinating relationship between your mind and your money:
• “Predictably Irrational,” Dan Ariely
• “Why Smart People Make Big Money Mistakes,” Gary Belsky, Thomas Gilovich
• “Stumbling on Happiness,” Daniel Gilbert
• “Thinking, Fast and Slow,” Daniel Kahneman
• “The Undoing Project,” Michael Lewis
• “Your Money & Your Brain,” Jason Zweig
Just as you can’t see your face without the benefit of a mirror, your brain has a difficult time “seeing” its own biases.
The first four self-inflicted biases that knock a number of investors’ off-course: anchoring, blind spot, confirmation bias and familiarity bias. Hopefully you can more readily recognize and defend against them the next time they’re happening to you.
What is it? Anchoring bias occurs when you fix on or “anchor” your decisions to a reference point, whether or not it’s a valid one.
When is it helpful? An anchor point can be helpful when it is relevant and contributes to good decision-making. For example, if you’ve set a 10 pm curfew for your son or daughter and it’s now 9:55 pm, your offspring would be wise to panic a bit, and step up the homeward pace.
When is it harmful? In investing, people often anchor on the price they paid when deciding whether to sell or hold a security: “I paid $31/share for this stock and now it’s only worth $29/share. I’ll hold off selling it until I’ve broken even.” This is an example of anchoring bias in disguise. Evidence-based investing informs us, the best time to sell a holding is when it’s no longer serving your ideal total portfolio, as prescribed by your strategic investment plans. What you paid is irrelevant to that decision, so anchoring on that arbitrary point creates a dangerous distraction.
BLIND SPOT BIAS
What is it? Blind spot bias occurs when you can objectively assess others’ behavioral biases, but you cannot recognize your own.
When is it helpful? Blind spot bias helps you avoid over-analyzing your every imperfection, so you can get on with your one life to live. It helps you tell yourself, “I can do this,” even when others may have their doubts.
When is it harmful? It’s hard enough to root out all your deep-seated biases once you’re aware of them, let alone the ones you remain blind to. In “Thinking, Fast and Slow,” Nobel laureate Daniel Kahneman describes (emphasis ours): “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Hint: This is where second opinions from an independent advisor can come in especially handy.)
What is it? We humans love to be right and hate to be wrong. This manifests as confirmation bias, which tricks us into being extra sympathetic to information that supports our beliefs and especially suspicious of – or even entirely blind to – conflicting evidence.
When is it helpful? When it’s working in our favor, confirmation bias helps us build on past insights to more readily resolve new, similar challenges. Imagine if you otherwise had to approach each new piece of information with no opinion, mulling over every new idea from scratch. While you’d be a most open-minded person, you’d also be a most indecisive one.
When is it harmful? Once we believe something – such as an investment is a good/bad idea, or a market is about to tank or soar – we want to keep believing it. To remain convinced, we’ll tune out news that contradicts our beliefs and tune into that which favors them. We’ll discount facts that would change our mind, find false affirmation in random coincidences, and justify fallacies and mistaken assumptions that we would otherwise recognize as inappropriate. And we’ll do all this without even knowing it’s happening. Even stock analysts may be influenced by this bias.
What is it? Familiarity bias is another mental shortcut we use to more quickly trust (or more slowly reject) an object that is familiar to us.
When is it helpful? Do you cheer for your home-town team? Speak more openly with friends than strangers? Favor a job applicant who (all else being equal) has been recommended by one of your best employees? Congratulations, you’re making good use of familiarity bias.
When is it harmful? Considerable evidence tells us that a broad, globally diversified approach best enables us to capture expected market returns while managing the risks involved. Yet studies like this one have shown investors often instead overweight their allocations to familiar vs. foreign investments. We instinctively assume familiar holdings are safer or better, even though, clearly, we can’t all be correct at once. We also tend to be more comfortable than we should be bulking up on company stock in our retirement plan.
As you learn and explore, we hope you’ll discover to prevent your behavioral biases from staging attacks on your financial resolve. But, forewarned is forearmed. You stand a much better chance of thwarting them once you know they’re there!
Having an objective advisor well-versed in behavioral finance, dedicated to serving your highest financial interests, and unafraid to show you what you cannot see for yourself is among your strongest defenses against all of the biases we’ll present throughout the rest of this series.
Ready to learn more? Next, installment we’ll continue through the alphabet, introducing a few more of the most suspect financial behavioral biases.Share