Welcome back to our “ABCs of Behavioral Biases.” Today, we’ll get started by introducing you to four self-inflicted biases that knock a number of investors off-course: anchoring, blind spot, confirmation, and familiarity bias.
What is it? Anchoring bias occurs when you fix on or “anchor” your decisions to a reference point, whether or not it’s a valid one.
When is it helpful? An anchor point can be helpful when it is relevant and contributes to good decision-making. For example, if you’ve set a 10 pm curfew for your son or daughter and it’s now 9:55 pm, your offspring would be wise to panic a bit, and step up the homeward pace.
When is it harmful? In investing, people often anchor on the price they paid when deciding whether to sell or hold a security: “I paid $11/share for this stock and now it’s only worth $9/share. I’ll hold off selling it until I’ve broken even.” This is an example of anchoring bias in disguise. Evidence-based investing informs us, that the best time to sell a holding is when it’s no longer serving your ideal total portfolio, as prescribed by your investment plans. What you paid is irrelevant to that decision, so anchoring on that arbitrary point creates a dangerous distraction.
What is it? Blind-spot bias occurs when you can objectively assess others’ behavioral biases, but you cannot recognize your own.
When is it helpful? Blind-spot bias helps you avoid over-analyzing your every imperfection, so you can get on with your one life to live. It helps you tell yourself, “I can do this,” even when others may have their doubts.
When is it harmful? It’s hard enough to root out all your deep-seated biases once you’re aware of them, let alone the ones you remain blind to. In “Thinking, Fast and Slow,” Nobel laureate Daniel Kahneman describes (emphasis ours): “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Hint: This is where second opinions from an independent advisor can come in especially handy.
What is it? We, humans, love to be right and hate to be wrong. This manifests as confirmation bias, which tricks us into being extra sympathetic to information that supports our beliefs and especially suspicious of – or even entirely blind to – conflicting evidence.
When is it helpful? When it’s working in our favor, confirmation bias helps us build on past insights to more readily resolve new, similar challenges. Imagine if you otherwise had to approach each new piece of information with no opinion, mulling over every new idea from scratch. While you’d be a most open-minded person, you’d also be a most indecisive one.
When is it harmful? Once we believe something – such as an investment is a good/bad idea, or a market is about to tank or soar – we want to keep believing it. To remain convinced, we’ll tune out the news that contradicts our beliefs and tune into that which favors them. We’ll discount facts that would change our minds, find false affirmations in random coincidences, and justify fallacies and mistaken assumptions that we would otherwise recognize as inappropriate. And we’ll do all this without even knowing it’s happening. Even stock analysts may be influenced by this bias.
What is it? Familiarity bias is another mental shortcut we use to more quickly trust (or more slowly reject) an object that is familiar to us.
When is it helpful? Do you cheer for your hometown team? Speak more openly with friends than strangers? Favor a job applicant who (all else being equal) has been recommended by one of your best employees? Congratulations, you’re making good use of familiarity bias.
When is it harmful? Considerable evidence tells us that a broad, globally diversified approach best enables us to capture expected market returns while managing the risks involved. Yet studies like this one have shown investors often instead overweight their allocations to familiar vs. foreign investments. We instinctively assume familiar holdings are safer or better, even though, clearly, we can’t all be correct at once. We also tend to be more comfortable than we should be bulking up on company stock in our retirement plan.
Ready to learn more? Next post we’ll continue through the alphabet, introducing a few more of the most suspect financial behavioral biases.
Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.
The ABCs of Behavioral Biases – Conclusion
The ABCs of Behavioral Biases (S–Z)
The ABCs of Behavioral Biases (O–R)
The ABCs of Behavioral Biases (H–O)
ABCs of Behavioral Biases – Series Intro
What is Portfolio Construction?
How Much Money Makes You Wealthy, Wealthier, or Wealthiest?
What is Estate Planning and Why is It Important?
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