The ABCs of Behavioral Biases Conclusion

We’ll wrap up our series, the ABCs of Behavioral Biases, by repeating our initial premise: Your own behavioral biases are often the greatest threat to your financial well-being.

We hope we’ve demonstrated the many ways this single statement can play out, and how often our survival-mode brains trick us into making financial calls that foil our own best interests.

Evidence-Based Behavioral Finance
But don’t take our word for it. Just as we turn to robust academic evidence to guide our disciplined investment strategy, so too do we turn to the work of behavioral finance scholars, to understand and employ effective defenses against our most aggressive behavioral biases.

Without the corrosive impact of these biases, behavioral finance might be of merely academic interest. But given how often – and in how many ways – our fight-or-flight instincts collide with our rational investment plans, it’s worth being aware of the tell-tale signs, so we can detect when a behavioral bias may be running roughshod over our higher reasoning. To help with that, here’s a summary of the biases we’ve covered throughout this series: 

 

The Bias

Its Symptoms

The Damage Done

Anchoring

Going down with the proverbial ship by fixing on rules of thumb or references that don’t serve our best interests.

“I paid $11/share for this stock and now it’s only worth $9. I won’t sell it until I’ve broken even.”

Blind Spot

The mirror might lie after all. We can assess others’ behavioral biases, but we often remain blind to our own.

“We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Daniel Kahneman)

Confirmation

This “I thought so” bias causes us to seek news that supports our beliefs and ignore conflicting evidence.

After forming initial reactions, we’ll ignore new facts and find false affirmations to justify our chosen course … even if it would be in our best financial interest to consider a change.

Familiarity

Familiarity breeds complacency. We forget that “familiar” doesn’t always means “safer” or “better.”   

By overconcentrating in familiar assets (domestic vs. foreign, or a company stock) we decrease global diversification and increase our exposure to unnecessary market risks.

Fear

Financial fear is that “Get me out, NOW” panic we feel whenever the markets turn brutal. 

“We'd never buy a shirt for full price then be O.K. returning it in exchange for the sale price. ‘Scary’ markets convince people this unequal exchange makes sense.” (Carl Richards)

Framing

Six of one or half a dozen of another? Different ways of considering the same information can lead to illogically different conclusions.

Narrow framing can trick us into chasing or fleeing individual holdings, instead of managing everything we hold within the greater framework of our total portfolio.

Greed

Excitement is an investor’s enemy (to paraphrase Warren Buffett.)

We can get burned in high-flying markets if we forget what really counts: managing risks, controlling costs, and sticking to plan.

Herd Mentality

“If everyone jumped off a bridge …” Your mother was right. Even if “everyone is doing it,” that doesn’t mean you should.

Herd mentality intensifies our greedy or fearful financial reactions to the random events that generated the excitement to begin with.

Hindsight

“I knew it all along” (even if you didn’t). When our hindsight isn’t 20/20, our brain may subtly shift it until it is.

If we trust our “gut” instead of a disciplined investment strategy, we may be hitching our financial future to a skewed view of the past.

Loss Aversion

No pain is even better than a gain. We humans are hardwired to abhor losing even more than we crave winning.

Loss aversion causes investors to try to dodge bear markets, despite overwhelming evidence that market timing is more likely to increase costs and decrease expected returns.

Mental Accounting

Not all money is created equal. Mental accounting assigns different values to different dollars – such as inherited assets vs. lottery wins.

Reluctant to sell an inherited holding? Want to blow a windfall as “fun money”? Mental accounting can play against us if we let it overrule our best financial interests.

Outcome

Luck or skill? Even when an outcome is just random luck, our biased brain still may attribute it to special skills. 

If we misattribute good or bad investment outcomes to a foresight we couldn’t possibly have had, it imperils our ability to remain an objective investor for the long haul.

Overconfidence

A “Lake Wobegon effect,” overconfidence creates a statistical impossibility: Everyone thinks they’re above average.

Overconfidence puffs up our belief that ​we’ve got the rare luck or skill required to

consistently “beat” the market, instead of patiently participating in its long-term returns.

Pattern Recognition

Looks can deceive. Our survival instincts strongly bias us toward finding predictive patterns, even in a random series.

By being predisposed to mistake random market runs as reliable patterns, investors are often left chasing expensive mirages.

Recency

Out of sight, out of mind. We tend to let recent events most heavily influence us, even for our long-range planning.

If we chase or flee the market’s most recent returns, we’ll end up piling into high-priced hot holdings and selling low during the downturns.

Sunk Cost Fallacy

Throwing good money after bad. It’s harder to lose something if we’ve already invested time, energy or money into it.

Sunk cost fallacy can stop us from selling a holding at a loss, even when it is otherwise the right thing to do for our total portfolio.

Tracking Error Regret

Shoulda, coulda, woulda. Tracking error regret happens when we compare ourself to external standards and wish we were more like them.

It can be deeply damaging to our investment returns if we compare our own performance against apples-to-oranges measures, and then trade in reaction to the mismatched numbers.

 

Next Steps: Think Slow

Even once we’re familiar with the behavioral biases that stand between us and clear-heading thinking, we’ll probably still be routinely tempted to react to the fear, greed, doubt, recklessness and similar hot emotions they generate.

Nobel laureate Daniel Kahneman helps us understand why in his book, “Thinking, Fast and Slow,” where he describes how we engage in System 1 (fast) and System 2 (slow) thinking: “In the picture that emerges from recent research, the intuitive System 1 is more influential than our experience tells us, and it is the secret author of many of the choices and judgments we make.”

In other words, we can’t help ourselves. When we think fast, our instincts tend to run the show; for better or worse, they’re the first thoughts that come to mind.

This is one reason an objective advisor can be such a critical ally, helping us move past our System 1 thinking into more deliberate decision-making for our long-term goals. (On the flip side, financial providers who are themselves fixated on picking hot stocks or timing the market on our behalf are more likely to exacerbate than alleviate our most dangerous biases.)

Investors of “Ordinary Intelligence”
Berkshire Hathaway Chairman and CEO Warren Buffett is a businessman, not a behavioral economist. But he does have a way with words. We’ll wrap with a bit of his timeless wisdom:

“Success in investing doesn’t correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

If we can remember this cool-headed thinking the next time we’re tempted to act on our investment instincts, Mr. Buffett’s got nothing on us (except perhaps a few billion dollars). But if you could use some help managing the behavioral biases that are likely lurking in your blind spot, give us a call. In combatting that which you cannot see, two views are better than one.