Welcome to the thirteenth installment in our Evidence-Based Investment Insights series: What Makes Your Brain Trick?
In our last piece, “The Human Factor,” we explored how our deep-seated “fight or flight” instincts generate behavioral biases that trick us into making investment mistakes. In this installment, we will explore behavioral biases, and how you can recognize the signs before making errors.
Behavioral Bias #1: Herd Mentality
Herd mentality is what happens to you when you see market movement and you are driven to join. The herd may be pursing a hot buying opportunity, such as a run on a stock or stock market sector, or fleeing a widely perceived risk, such as a country in economic turmoil. Either way, as we covered in “Siren Song of Daily Market Pricing,” following the herd puts you on a dangerous path toward buying high, selling low and incurring unnecessary expenses en route.
Behavioral Bias #2: Recency
You put your long-term plans at risk when you give recent information greater weight than historic evidence warrants. From our earlier piece, “The Business of Investing,” we know stocks have historically delivered premium returns over bonds. And yet, whenever stock markets dip downward, we typically see individuals making decisions based on short-term information.
Behavioral Bias #3: Confirmation Bias
Confirmation bias is the tendency to favor evidence supporting our beliefs rather than following the full picture. We seek news that supports our belief structure and ignore anything requiring us to radically change our views. Without evidence-based, peer-reviewed research, our minds want us to be right so badly we can outsmart the market - even against our best interests as investors.
Behavioral Bias #4: Overconfidence
In “Your Money & Your Brain,” Jason Zweig describes overconfidence in action when he asks: “How else could we ever get up the nerve to ask somebody out on a date, go on a job interview, or compete in a sport?” Sometimes, a degree of overconfidence can be beneficial. But it becomes dangerous when it tricks us into believing we can consistently beat the market by being smarter or luckier than average. In reality, as we described in “Group Intelligence and the Market,” it is best to patiently participate in the market’s expected returns, instead of trying to go for broke – potentially literally.
Behavioral Bias #5: Loss Aversion
As a flip side to overconfidence, we have loss aversion, meaning we are significantly more pained by the thought of losing wealth than we are excited by the prospect of gaining it.
One way loss aversion plays out is when investors prefer to sit in cash or bonds during bear markets – or even when stocks are going up, but a correction seems overdue. The evidence clearly demonstrates you are likely to end up with higher long-term returns by at least staying put, if not bulking up on stocks while they are “cheap.” And yet, even the potential for future loss can be more compelling than the likelihood of long-term returns.
Behavioral Bias #6: Sunken Costs
We also have a terrible time admitting defeat. When we buy an investment and it sinks lower, we tell ourselves we do not want to sell until it is at least back to what we paid. In a data-driven strategy, the evidence is strong that this sort of sunken-cost logic leads people to throw good money after bad. By refusing to let go of past losses – or gains – that no longer suit your portfolio’s purposes, emotional choices can cloud an otherwise solid investment strategy.
Even once you are aware of your behavioral stumbling blocks, it can still be devilishly difficult to avoid tripping on them. An objective advisor can help you see and avoid collisions with yourself.
In the next and final installment of our Evidence-Based Investment Insights, we will tie together the insights shared throughout the series. Of course, there is no need to wait. If you have questions or ideas you would like to explore right away, we would love to hear from you today.