We’ll wrap 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 your most aggressive behavioral biases.
By the way, even as we released our series, we were delighted to congratulate University of Chicago Professor Richard Thaler for his recent Nobel Prize in Economic Sciences, recognizing his lifetime contributions to behavioral economics!
If there weren’t so much damage done, behavioral finance might be of merely academic interest. But given how often – and in how many ways – your fight-or-flight instincts collide with your rational investment plans, it’s worth being aware of the tell-tale signs, so you can detect when a behavioral bias may be running roughshod over your 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 your 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 you to seek news that supports your 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) you decrease global diversification and increase your 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 you into chasing or fleeing individual holdings, instead of managing everything you hold within the greater framework of your total portfolio. |
| Greed | Excitement is an investor’s enemy (to paraphrase Warren Buffett.) | You can get burned in high-flying markets if you 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 your hindsight isn’t 20/20, your brain may subtly shift it until it is. | If you trust your “gut” instead of a disciplined investment strategy, you may be hitching your 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 you if you let it overrule your best financial interests. |
| Outcome | Luck or skill? Even when an outcome is just random luck, your biased brain still may attribute it to special skills. | If you misattribute good or bad investment outcomes to a foresight you couldn’t possibly have had, it imperils your 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 your belief that you’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 you chase or flee the market’s most recent returns, you’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 you’ve already invested time, energy or money into it. | Sunk cost fallacy can stop you from selling a holding at a loss, even when it is otherwise the right thing to do for your total portfolio. |
| Tracking Error Regret | Shoulda, coulda, woulda. Tracking error regret happens when you compare yourself to external standards and wish you were more like them. | It can be deeply damaging to your investment returns if you compare your own performance against apples-to-oranges measures, and then trade in reaction to the mismatched numbers. |
Survivorship Bias: Seeing Only the Winners
Survivorship bias is a classic mental trap where we end up focusing solely on the “winners” or “survivors” of a process, while overlooking all the “losers” or those who fell by the wayside along the journey. This can distort our conclusions—often in dramatic ways—because we’re only seeing a subset of the whole picture.
How does this bias sneak into our thinking? Imagine you’re reviewing the backgrounds of today’s most celebrated entrepreneurs. It may look like dropping out of college is the secret sauce for success because so many business icons took that route. But here’s the rub: for every college dropout billionaire, there are thousands more who left school and never struck gold. By concentrating just on the visible success stories and ignoring the far larger pool of less successful attempts, we risk drawing lessons that simply don’t hold up for the rest of us.
In research, this bias can crop up beyond business as well. For example, if a medical study only analyzes patients who finish a treatment, it might miss critical information from those who dropped out—whether from side effects, lack of results, or other reasons. The resulting conclusions could be skewed because a crucial part of the data has vanished behind the scenes.
Recognizing survivorship bias means remembering to look for the invisible stories: Who didn’t make it to the end, and why? Without accounting for those “missing” cases, we may fall for misleading narratives and flawed advice.
The Baader-Meinhof Phenomenon: When Coincidences Multiply
Have you ever learned a new word—let’s say “simulacrum”—and then, suddenly, it seems to be lurking everywhere you look? That’s not the universe playing tricks on you, but rather the Baader-Meinhof phenomenon, also known as frequency illusion. In essence, once you encounter something novel or unfamiliar, your brain puts it on a kind of “mental alert.”
Here’s how it works: after you bump into, say, a philosophical term in class, your heightened awareness makes every subsequent appearance leap out at you—whether it’s in the title of an offbeat theater production, pixelated across a video game, or even belted out by a niche metal band. Nothing about the word itself has changed; your radar for it has simply become extra sensitive.
It’s a quirky cognitive bias, and it arises from your mind’s tendency to zero in on recent information. Rather than these words or concepts suddenly flooding your world, it’s your attentiveness that’s dialed up, making them appear more frequent than they truly are.
Availability What you see is (not always) what you get. Our tendency to judge how common or risky something is based on the stories, headlines, or events most fresh in our minds—even if those aren’t the most accurate or relevant examples. Find yourself convinced that shark attacks lurk behind every ocean wave after binge-watching sensational news stories? That’s availability bias at play. Instead of making decisions anchored to reality, we unconsciously inflate the importance of vivid or recent information, leaving us vulnerable to all sorts of skewed assessments about risk or frequency.
Halo Effect Letting one shiny trait blind you to the rest. When a single positive feature about someone or something stands out, we tend to let it color our entire impression—even when we know almost nothing else. Ever find yourself assuming someone is trustworthy just because they have a warm smile, or believing a product is top quality just because the packaging looks high-end? That’s the halo effect at work: first impressions sneakily shape all the judgments that follow, whether you’re evaluating your neighbor or the latest gadget on the shelf.
Next Steps: Think Slow
Even once you’re familiar with the behavioral biases that stand between you and clear-heading thinking, you’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 your experience tells you, and it is the secret author of many of the choices and judgments you 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 you move past your System 1 thinking into more deliberate decision-making for your long-term goals. (On the flip side, financial providers who are themselves fixated on picking hot stocks or timing the market on your behalf are more likely to exacerbate than alleviate your 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 you can remember this cool-headed thinking the next time you’re tempted to act on your investment instincts, Mr. Buffett’s got nothing on you (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.