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Emotional Investing and the Consequences of Behavioral Biases

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We all experience distractions in the media, uncertainty in the markets, or pressure to buy and sell from friends, colleagues, and so-called financial gurus. All these factors can directly challenge an investor’s ability to make consistent, rational and logical investment decisions. This barrage of information coupled with inherent behavioral biases can make investing a challenge for most people. How you behave and react to the information available will play an important role in your financial success.

Behavioral Finance has been an academic area of study since the early 2000s. It gained international recognition when Daniel Kahneman, a psychology professor at Princeton University, published research that demonstrated “repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.” Dr. Kahneman’s findings won him the Nobel Prize in economics in 2002. His research strongly suggests that investors will often make decisions based on their emotions rather than on logic and historical data – even if it’s right in front of them. If you think you are not susceptible to them, think again.

Below we will outline some of the most common behavioral biases. That way you, as an investor, can be educated and prepared when you encounter them. If you are familiar with these biases, you will be able to identify and avert them in the future.

Home Bias

Most of us root for local teams, prefer our local coffee shop and are certain that our mom’s apple pie is the best in the world. When making investment decisions, people tend to prefer investing in their own countries. This home bias can limit an investor when there is an entire world of opportunity beyond investing in US company stocks. Investing in just one region means that you are not well diversified. Geographic diversification is highly recommended for both protection and opportunity.

Loss Aversion

Put simply, we dislike losing much more than we like winning. In an investing setting, this can lead you to make choices that will not allow you to satisfy your goals. An unreasonable aversion to risk coupled with unjustified optimism causes many investors to make grand forecasts but timid choices. From a long-term investment standpoint, loss aversion bias is troubling. Investors need to assume a certain level of risk to grow their portfolio so they can meet their needs after they retire. If the investor is unable to take an appropriate level of risk, their portfolio may not outpace inflation and will not be able to fund all their goals.

Optimism Bias

A recent study by the Association for Psychological Science asked drivers how they would rate their own driving. 80% of those polled stated that their driving skills were above average. I’m no mathematician, but I’m pretty sure only 50% of people can be considered “above average.” The results of this study can be seen in other aspects of life as well. Many people believe they are “above average” when it comes to their investment decisions. Optimism bias can lead us to be more hopeful about investments than we should be. According to a State Street Center for Applied Research study conducted in 2012, 2/3 of investors rated their financial acumen as advanced. When these participants took a financial literacy exam, the average score was only 61%. If they were still in school, the average grade of these participants would have been a whopping D-. But of course, that does not represent your knowledge. 

Recency Bias

We are hardwired to use our recent experiences as a benchmark for what might happen next. When the market goes down, investors fear that it will continue to do so. If they would have looked at the market chart below, they would see that the likelihood of the market continuing to fall and never climbing back up is, historically speaking, infinitesimally low. But pesky recency bias has our brains thinking only of yesterday and not 10 or 20 years back. This bias can also present itself when the market is doing very well. Be careful and don’t chase returns, it will likely backfire.

Stock Market Since 1900

Confirmation Bias

The scientific method recommends carefully gathering facts, evaluating them and then coming to a conclusion based on your findings. We like to think that we all follow this method in our decision-making process but, the truth is, we don’t. People, by nature, tend to reach a conclusion first and then seek out information that supports the conclusion they already have.

We develop narratives to support our unique concept of reality and, when a conclusion already fits into the narrative we’ve created, it’s comforting. When it comes to investing, confirmation bias can lead you to make portfolio decisions that support your existing investment philosophy or preference for a particular stock. Don't get caught seeking information that serves to perpetuate your beliefs rather than reviewing all the information available.

Stay Focused on Your Goals

Hindsight is twenty-twenty. Recognizing behavioral biases before they negatively impact your investment decisions will serve you and your portfolio well. Working with a fiduciary financial advisor to help you define your goals and manage your portfolio is one of the safest ways to manage your behavioral biases. As part of a holistic financial planning program, a fee-only financial planning firm should work to help each client to better understand the behaviors that can harm investment performance.

 

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