Investors often make poor investment decisions due to innate human tendencies. Behavioral finance is the field of study which explores these tendencies. Educating yourself in common behavioral finance biases can really help. Awareness can aid you in making more objective and rational decisions by recognizing these behavioral finance biases which may negatively impact decision making.
It is easy to become overconfident when your investments are performing well. However, the outperformance may be mostly due to luck, a strong bull market, or some other reason. But when you are overconfident, you overestimate your abilities and underestimate risk. You believe that all the gains are attributable to your skill and ability (self-attribution bias).
Some may also have a false belief that they can control or influence the performance of their investments when in reality they cannot do so (illusion of control bias).
Hindsight bias can also lead to overconfidence. This is when investors may see past events as having been predictable.
This can lead to aggressive or leveraged investing. Excessive trading is common with overconfidence. It can also lead to investments in riskier areas such as derivatives, or those in which you have little knowledge. Needless to say, overconfidence can lead to losses and can sabotage your investment goals.
Confirmation Bias and Cognitive Dissonance
We often tend to rely more on information that supports our core beliefs and values. This is called confirmation bias or rationalization.
Cognitive dissonance is when negative emotions are created in light of information that contradicts established beliefs.
As an example, let’s say you believe that utility stocks and REITs are the best investments due to their stability and income generating features. As such, you welcome analyst reports and media coverage which praise such stocks as wise investments (confirmation bias).
However, you then see a report which indicates that due to the expected rise in interest rates, high dividend stocks such as utilities and REITs may underperform. This information may cause unease (cognitive dissonance) since it is contradictory to the fact that REITs and utilities are always the best investments.
This is when you rely too much on the initial piece of information available (the “anchor”) to you. However, new and more useful and relevant information may be available. As such, placing too much weight on the initial information (“anchor”) and not enough on new information may lead to poor investment decisions.
For example, you read from a respected source that stocks have historically returned about 10% per year. But due to recent above average returns and expected increases to interest rates, new reports predict that returns in the next few years will likely be much lower on average.
You may incorporate this new information into your own expectations, but anchoring to the 10% initial value may not allow for a sufficient adjustment to expectations.
Interpreting new information based on past experiences and stereotypes is called representativeness.
As a hypothetical example, you see on the news that technology companies are revolutionizing the world and their stocks have outperformed. You even use some of their cool gadgets. You are also aware that banks played a part in a recent financial crisis, and their stock prices have underperformed. Not to mention that you may have experienced some frustration in applying for a loan or dealing with excessive bank fees.
As a result, representative bias may lead you to believe that technology companies are currently better investments than bank stocks. However, this may or may not be the case. It is possible that technology stocks could be overvalued, while the bank stocks are undervalued. But you may not see this because you are influenced by your past experiences and stereotypes of each sector.
You may be so afraid of suffering losses that you do not care about achieving gains. This can lead to investing that is too conservative. In such a case your investment returns may be too low, delaying or even preventing you from reaching your financial goals. Investing that is too conservative may also make you more prone to the negative effects of inflation over the long term.
Self control bias is when you lack discipline to do what is necessary now in order to meet your future goals. For example, you may know that you need to cut back on current consumption in order to save and invest for retirement. But a self-control problem or bias may mean you lack the discipline required to make the necessary cuts to achieve your saving and investing goals.
Other examples include being aware of benefits such as diversification and compounding, but failing to implement and take advantage of such concepts.
Individuals often make decisions based on the way in which a question or information is presented (framed).
For example, your financial advisor may tell you that with equities, you may experience losses of 20% or more in any given year, but average annual returns will be about 10% over time. You figure the average return is not worth the volatility. This may result in a decision to avoid the stock market.
But if the advisor instead presents a chart showing you how despite the volatility, these same returns, when compounded over time, can allow you to reach your retirement goals, you may make a different decision.
Sometimes we make certain investment choices in order to avoid or minimize the feeling of regret due to a mistake or otherwise poor investment decision. Fearing regret can lead to inaction when action is necessary. Also, it can result in investing in areas in which you have familiarity and comfort, when other investments may be a better fit for your circumstances.
Oftentimes investors look at only the nominal returns of their investments without considering the effects of inflation (or deflation).
You may be happy that you earned a 5% annual nominal return on your investments. But if inflation for the year was 3%, you had a real return (nominal return adjusted for inflation) of only 2%. The purchasing power of your money decreased due to inflation.
Alternatively, you may be unhappy about a nominal return of only 2%. But if inflation was negative 3% (deflation), your real return was 5% for the year. The purchasing power of your money increased.
So it’s important to understand the real returns of your investments, and to avoid making investment decisions based on nominal returns only.
Treating money differently based on how you acquired it, it’s purpose, or where you keep it (i.e, separate bank account) is called mental accounting. Mental accounting can be very helpful in terms of putting funds into different “buckets” for various goals. This allows you to be more disciplined in applying a certain risk tolerance and objectives to that money.
However, it is also useful to remember that money is fungible. Regardless of where it came from or what it’s purpose is, it will affect your net worth the same way.
For example, it is important to treat easily acquired funds such as a gift or inheritance with the same care as money for which you worked very hard to acquire. Mental accounting causes some to freely spend or to invest aggressively money acquired easily (“windfall”). At the same time, these individuals may be more hesitant to spend or invest money earned.
Making decisions based primarily on which information or experiences come to mind first is an example of availability bias.
Let’s say you had a negative experience investing in international stocks years ago. Now your advisor recommends putting an allocation of international stocks into your portfolio as part of a diversified strategy. You may nix this recommendation based on your personal experience which quickly and clearly comes to mind.
Status Quo Bias
Sometimes doing nothing when action is necessary can be harmful to your investment portfolio. This is called status quo bias. You may do nothing due to ignorance or laziness. Maintaining the status quo when your personal situation changes and/or an action such as rebalancing or diversification is needed, can have negative consequences.
We often tend to think more highly of an investment when we own it. So you may prefer to stick with a particular investment (which you already own), for example, when another one may be a better option under the circumstances.
Heuristic learning process
It is common for investors to want to simplify things in order to make decisions easier. In doing so, we often follow popular shortcuts or rules of thumb as a convenience. However, such decision making processes may not be ideal. For example, someone may determine the stock allocation in his or her portfolio based on the “100 minus your age” rule of thumb.
Although this rule of thumb may work for many individuals, it may not be ideal for others. Specific circumstances, goals, and risk tolerance may call for a more detailed or different approach to asset allocation.
For example, let’s say you are a 75 year old retiree and you do not need to live off of your retirement account savings. You have a defined benefit employer pension, social security, and taxable savings which you use for living expenses. As such, you plan on passing your retirement accounts on to your heirs. In such a case having only a 25% allocation to stocks (100-75) may be too conservative.
It is very common for investors to place more weight on more recent events than older ones. For example, the stock market has returned on average about 10 to 11% per year since 1926. However, after the financial crisis of 2007-2009, many investors avoided the stock market (and still do). The reason being that they remember the more recent negative past rather than the longer positive history of the stock market.
Conservatism and Aversion to Ambiguity
It is natural to prefer things we know well and with which we are familiar. However, sometimes it may make more sense to invest in something which may be new or with which we are not as familiar or comfortable.
For example, let’s say you are very familiar with equity (stock) investing. But you need some fixed income investments to reduce risk in your portfolio. Sticking only with the familiar stock investments can have negative future consequences.
As such, it may be prudent to move beyond your area of expertise. You can educate yourself to gain more knowledge and/or consult an advisor. You can also invest in a fixed income fund (in this example), which employs experienced portfolio managers to oversee the investments with which you are less comfortable.
It would be great if we all made perfectly rational, logical, and unbiased decisions all the time. Unfortunately, that is not realistic. We are all subject to certain psychological behavioral finance biases from time to time. This can negatively affect our decision making.
The key is to understand and be aware of these behavioral finance biases. This will help you to recognize them during your decision making process. In turn, this should minimize the extent to which specific biases play a role in the final decision.