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Key Investment Insights: Investors’ Behavioral Biases

October 14, 2014

Welcome to the next installment in our series of Key Investment Insights. In our last piece, “The Human Factor in Evidence-Based Investing,” we explored how our deep-seated “fight or flight” instincts can generate an array of behavioral biases that trick us into making what could be significant money-management mistakes. In this installment, we’ll familiarize you with a half-dozen of these more potent biases, and how you can avoid sabotaging your own best-laid investment plans by recognizing the signs of a behavioral booby trap.

Behavioral Bias No. 1: Herd Mentality

Herd mentality is what happens to you when you willingly join the market stampede, despite not knowing whether the herd is hurtling toward a hot buying opportunity or fleeing a widely perceived risk. Either way, following the herd puts you on a dangerous path toward buying high or selling low and incurring unnecessary expenses along the way.

Behavioral Bias No. 2: Recency

Your long-term plans are at risk when you succumb to the tendency to give recent information greater weight than the long-term evidence warrants. We know that, historically, stocks have delivered premium returns over bonds, yet whenever a stock market dips, we typically “see” only recency at play, as droves of safe haven-seeking investors sell their stocks (or vice-versa, when bull markets are on a tear).

Behavioral Bias No. 3: Confirmation Bias

Confirmation bias is the tendency of an investor to favor that evidence which supports his or her beliefs and to dismiss (or even completely ignore) any evidence which refutes it. Of all the behavioral biases, the confirmation bias may be the greatest reason why a rigorous, peer-reviewed approach becomes so critical to objective decision-making. Without that, our mind – so desperately wanting to be right – will “rig” the game for us, even against our best interests as an investor.

Behavioral Bias No. 4: Overconfidence

There are reams of data which suggest that most people (but especially men) believe that their acumen is above average. While overconfidence might be cute in a small child, in investing, it’s not so cute. In fact, it can be outright dangerous; overconfidence tricks us into losing sight of the fact that investors cannot expect to consistently outsmart the collective wisdom of the market.

Behavioral Bias No. 5: Loss Aversion

On the flip side of overconfidence, we may also be endowed with an over-sized dose of loss aversion. That means we have significantly more angst over the thought of losing wealth than excited by the prospect of gaining it. As Jason Zweig of “Your Money and Your Brain” states, “Doing anything – or even thinking about doing anything – that could lead to an inescapable loss is extremely painful.”

For example, investors may prefer to be in cash or bonds during a bear market, or even a bull market when it seems a correction might be due.  This is true even though the evidence clearly shows that you could end up with higher long-term returns by buying stocks or, at the very least, by staying put. Yet even the potential for a future loss can be a more compelling emotional stimulus than the likelihood of long-term gains.

Behavioral Bias No. 6:  Sunk Costs

As a rule, investors have a difficult time acknowledging defeat. When we buy an investment and it sinks lower, we convince ourselves to hold onto it until we can recoup what we’ve paid. In a data-driven strategy, there is compelling evidence that this sort of sunk-cost logic leads people to throw good money after bad. By refusing to let go of past losses – or even gains that no longer suit your portfolio’s purposes – an otherwise solid investment strategy becomes clouded by emotional choices and debilitating distractions.

Your Takeaway                                       

So there you have it; six behavioral biases, with many more worth exploring in Zweig’s and others’ books on behavioral finance. We hope you will take the time to learn more, because it can help you become a more confident investor.  However, even if you are aware of potential behavioral stumbling blocks, it can still be devilishly difficult to avoid tripping on them.  This is why we suggest working with an objective investment advisor to help you see and avoid a collision.

In the next and final installment of Key Investment Insights, we look forward to tying together the insights shared throughout the series.

 

 

Key Investment Insights: The Human Factor in Evidence-Based Investing

October 9, 2014

Welcome to the next installment in our series of Key Investment Insights.

In our last piece, “What Has Evidence-Based Investing Done for Me Lately?” we wrapped up our conversation about ways to employ stock and bond market factors within a disciplined investment strategy.  Our goal was to find new evidence-based insights from more recent research.

We turn now to the final and, arguably, most significant factor in your evidence-based investment strategy: the human factor.  In short, your own often impulsive reactions to market-changing events can easily trump any other market challenges you might face.

Exploring the Human Factor

We may know everything there is to know about capital markets, and we may be cognizant of all the solid evidence available to guide our rational decisions, but the fact is, in spite of all that, we’re still human. You see in the previous sentence that word “rational;” well, the truth is sometimes we’re just not.  We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions.  Rather, what we’ve got churning and brewing are chemically generated instincts and emotions that could spur us to leap long before we have time to look.

Physiologically, rapid reflexes often serve us well.  Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running without pause to think, while his or her laughter elicits an instant outpouring of love.

But in finance, where it is said only the coolest heads prevail, many of our baser instincts can cause more harm than good. If you don’t know that they’re happening or don’t manage them when they do, your brain signals can trick you into believing you’re making an entirely rational decision when, in fact, you’re being overpowered by an ill-placed and ill-timed “survival of the fittest” reaction.

Put another way, neurologist and financial theorist William J. Bernstein, M.D., Ph.D. says, “Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.”

Behavioral Finance, Human Finance

To study the relationships between our head and our financial health, there is another field of evidence-based inquiry known as behavioral finance. What happens when we stir up that Petrie dish of financial pathogens?

Wall Street Journal columnist Jason Zweig’s “Your Money and Your Brain” provides a good guided tour of the findings, describing both the behaviors and the goings on inside your head which can generate those behaviors; for example:

  • When markets tumble – Your brain’s amygdala floods your bloodstream with corticosterone. Fear clutches at your stomach and every instinct points the needle to “Sell!”
  • When markets unexpectedly soar – Your brain’s reflexive nucleus fires up within the nether regions of your frontal lobe. Greed grabs you by the collar, convincing you that you had best act soon if you want to carpe diem and “Buy!”

An Advisor’s Greatest Role: Managing the Human Factor

Beyond such market-timing instincts that can lead you astray, your brain cooks up plenty of other insidious biases to influence your investment activities. To name but a few, there’s also confirmation bias, hindsight bias, recency bias, overconfidence, loss aversion, sunken costs and herd mentality.  Given the myriad of instinctual responses that can lead you astray, it’s not easy to remain calm and “stay the course.”  The soundest decision is to have an impartial and unbiased investment advisor help you remain on the path you have carefully chosen.

DFA Investment Principles Slide 25

 

 

 

 

 

 

 

You can click on the graph for a better view.  Then click back to continue reading.

Your Takeaway

Managing the human factor in investing is another way an evidence-based financial practitioner can add value.  Zweig observes, “Neuroeconomics shows that you will get the best results when you harness your emotions, not when you strangle them.”  By spotting when investors are falling prey to a behavioral bias, we can hold up an evidence-based mirror for them, so they can see it too.  In our next piece, we’ll explore some of the more potent behavioral foibles investors face.

Key Investment Insights: What Has Evidence-Based Investing Done for Me Lately?

October 2, 2014

Welcome to the next installment in our series of Key Investment Insights. In our last piece, we introduced three key stock market factors (equity, value and small-cap) plus a couple more for bonds (term and credit) that have empirically formed the basis for evidence-based portfolio construction.

Continued inquiry has found additional market factors at play, with additional potential premiums (which, of course, are a result of market risk and/or risky behaviors). In academic circles, the most prominent among these factors are profitability and momentum:

  • Profitability – Highly profitable companies have delivered premium returns over low-profitability companies.
  • Momentum – Stocks which have done well (or poorly) in the recent past tend to continue to do the same for longer than chance would explain.

A Closer Look at Newer Factors

As expected, there are a few caveats.

  • Wet Paint Warning – While so-called “new” factors may or may not really be so new, our ability to isolate them is more recent and as a result, some among the evidence-based community are still assessing their staying power.
  • Cost versus Reward – Just because a factor does theoretically exist doesn’t mean it can be implemented in real life and, even if it can, that it is worth implementing. We must be able to capture an expected premium without generating costs beyond its worth.
  • Competing Factors – Sometimes, the inclusion of one factor in an investment strategy results in the sacrificing of another. For example, as Jared Kizer explains in his Multifactor World blog post, “One generally can’t tilt toward both value and momentum at the same time, because the two strategies tend to be highly negatively correlated.” Benefits and trade-offs must first be carefully considered.

As a result, opinions vary on when, how or even if, profitability, momentum and other newer factors should play a role in current portfolio construction. To help you determine whether any newer factor makes sense for you, let’s look at how investment information is assessed.

Investment Information: A Double-Edged Sword

Relentless questioning from scholars and practitioners has been essential to evidence-based investment theory and application, dispelling illusions and misconceptions and laying the foundation for other insights.

But, with a glimpse of the day’s headlines, one can’t help but notice a seemingly never-ending stream of ideas, often from competing, sometimes conflicting, voices of authority. Information overload can, unfortunately, do as much harm as good.

Investment Reality: Choose Your Allies Carefully

So, how do you know what information to heed and what to ignore? This is where we believe an evidence-based advisor relationship is critical to your wealth and well-being. As we outlined in “The Essence of Evidence-Based Investing,” whenever we assess the validity of existing and emerging market insights, we ask pointed questions that can take years to resolve:

  • Have the results been replicated over time and around the world?
  • Is there robust analysis, not only from industry insiders but from disinterested academics?
  • Has it survived extensive peer review, if not unscathed, at least free of mortal wounds?

Your Takeaway

By considering each new potential factor according to strict guidelines, our aim is to extract the diamonds of promising new evidence-based insights from the considerably larger piles of misleading misinformation. We feel you are best served by heeding those who take a similar approach with their advice. In our next Key Insight, we turn to a factor which we believe may be the most influential of all: you and your financial behavior