The field of Behavioral Finance attempts to understand why investors sometimes behave in ways that could be detrimental to their long term goals. Examples of this outside of the investing world include things like overeating - we know that eating a healthy diet and getting lots of physical exercise contributes to a healthier and hopefully longer life. And yet, speaking for myself, the lure of the sofa and the nachos can certainly sidetrack my best intentions. There are many situations in which people make decisions despite overwhelming evidence that those choices are dangerous and potentially lethal.
How does this relate to investing? Standard finance assumes that individuals make economic decisions with perfect rationality, self-interest and information. Otherwise stated, investors are rational. Behavioral finance assumes that investors are human. And humans make decisions that may not be rational but are nonetheless understandable given their personal beliefs, judgments and biases. And it is these biases, or blind spots, that lead to errors in judgement that can sidetrack a long-term investment strategy.
Biases can fall into two classes – cognitive biases and emotional biases. Here are some examples of each – see if you recognize any of these.
Hindsight bias – Hindsight bias occurs when we believe that an actual outcome or occurrence was perfectly predictable before the fact (for example, “I knew the market was overvalued and ripe for a crash”). However, at that time in the past, before the market decline, there were many possible outcomes and would have been impossible to know with certainty what would transpire. Also known as the “knew-it-all-along” effect.
Confirmation bias – this is a type of selective perception where people gravitate to ideas that support their own beliefs, and ignore or discredit ideas that contradict them. This bias plays out significantly in US politics these days – conservatives believe that media outlets such as CNN and MSNBC produce “fake news” while Fox News is seen as more truthful and informative. And, of course for liberals, the opposite is true. In investing, if we believe owning dividend stocks is the best approach, then we will discount reports or information that suggests alternative approaches are better.
Overconfidence – People tend to overestimate their own abilities. For example, if you ask thousands of people to rate their driving ability, 75% will rank themselves as above average (of course, that can’t be true in actuality). In investing many believe that they have superior abilities to predict future stock price movements. As we know, those price movements can be very random and subject to conditions, both known and unknown, that we cannot possibly predict.
Loss-Aversion - People feel the pain of loss with twice the intensity that they feel joy from a gain. In investing this means that people will hang on to losing positions longer than they will winning positions, even if the outlook for the losing security has deteriorated.
Status quo - this is the bias that encourages people to leave things as they are when faced with a wide variety of options. This can result in investors holding onto stock positions that they are familiar with or have a long-term emotional attachment rather than making a decision to diversify a portfolio, even if that makes more logical sense.
These are just a few examples of the potentially hundreds of biases we exhibit in all aspects of our daily lives. In investing, the usual outcome of portfolios built subject to too many of these biases is under-diversification, and that can be extremely harmful to long term investment success.
The point here is not to be too hard on ourselves – I personally have been pre-disposed to many behavioral biases both as a private investor and as an Advisor. But being aware of them helps us to devise investment strategies that override our biases and work to create a long term, positive investment experience. Developing a long-term investment strategy, building an investment plan and a well-diversified portfolio, meeting with your advisor regularly to review, and focusing on the things we can control will help ensure a positive investment experience and achievement of our goals.
Stay happy, stay safe, stay well!
The CM Group