STORY OF THE WEEK
COMMON BEHAVIORAL BIASES AND HOW TO OVERCOME THEM
As investors, we are often our own worst enemy. We may believe we are making rational decisions, but we frequently take mental shortcuts or allow emotions to cloud our judgment. Generally referred to as ‘behavioral biases,’ these tendencies lead investors astray in predictable fashion. The problem is so pervasive that a field of study (behavioral finance) was spawned to identify and categorize these common errors. The challenge to avoid behavioral biases exists for both novice and professional investors alike.
Behavioral biases are generally grouped into two categories. The first group is referred to as cognitive biases. These are mental errors that occur when analyzing and interpreting information. Dozens of cognitive biases have been identified in academia. The world is extremely complex, and even mundane decisions would be utterly exhausting if we carefully analyzed every variable and potential outcome. To function with any degree of efficiency, people rely on mental shortcuts. Often referred to as ‘heuristics,’ these shortcuts help people to avoid analysis paralysis but can also lead to poor decisions.
The second category is referred to as emotional biases. As the name implies, these biases stem from emotional impulses rather than analytical error. Often times fear and greed are the primary drivers here. Below are a few examples of prevalent cognitive and emotional biases and how they manifest themselves in investor behavior.
This cognitive bias reflects the tendency to seek out evidence that confirms existing beliefs and discount any evidence to the contrary. It is related to ‘cognitive dissonance,’ or the pain one feels when forced to reconcile new information that challenges existing beliefs.
Confirmation bias can lead to holding concentrated positions in certain companies and/or sectors. Negative information that might be a warning an investor should reduce their concentrated position and diversify may be ignored, exposing the investor to increased risk. Additionally, positive information about a particular asset class or strategy could also be ignored if it contradicts existing beliefs. This could lead to a missed opportunity to enhance returns.
This cognitive bias refers to the tendency of people to estimate the probability of a particular outcome based on how easily those outcomes come to mind. People tend to believe that recent and/or easily recalled cases are more likely than those that are difficult to remember or understand.
This bias can cause investors to overreact to recent news or market conditions. It can also lead people to make investments based on something they recently heard, as opposed to investing on the basis of thorough analysis.
This emotional bias highlights the fact that people feel the pain of losses more acutely than the pleasure of gains. In fact, studies have shown that people feel the pain of loss twice as intensely as any enjoyment from gains.
Loss aversion often leads investors to hold on to bad investments rather than lock in a loss by selling. Conversely, it can also cause investors to sell their winners too early. Additionally, ‘myopic loss aversion’ is related to the fact that the more an investor looks at their portfolio, the more likely they are to see small and transitory investment losses. Since investors feel the pain of loss twice as much as the pleasure of gains, investors may take less risk than they would otherwise be able to. In doing so, they may lower the likelihood of achieving their long-term goals.
This emotional bias leads people to overestimate their abilities when it comes to investing. They believe they are smarter, more capable, and have access to better information than they really do.
This bias can lead to investors holding insufficiently diversified portfolios, underestimating risk, and trading excessively.
Unfortunately, awareness alone is not enough to insulate investors from the damaging effects of behavioral biases. Daniel Khaneman, a Nobel Laureate and one of the founders of the behavioral economics field, once said in a speech that he had 40 years of experience studying biases and still commits them! So if the person responsible for identifying many of the biases can’t avoid them, what hope do investors have?
A powerful tool investors can use to avoid these critical mistakes is a financial plan. A major pillar of the planning process is the establishment of a long-term investment strategy, referred to as a strategic asset allocation. The key is to establish the strategy in advance, ahead of the inevitable market swings, and then stick to it. By doing this, investors can avoid the need to make those stressful decisions that are ripe for damaging behavioral biases in the first place!