Key Investment Insights: Investors’ Behavioral Biases
October 14, 2014
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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.
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.