Behavioral Investing - Helping Investors Understand Their Own Biases

Behavioral finance -- or how our behavioral biases impact our best financial decision making -- wasn't even an official "thing" until relatively recently. And yet, legendary economist and investor Ben Graham commented on its essence decades ago, when he observed the following:

The investor’s chief problem – and even his worst enemy – is likely to be himself.

Benjamin Graham (1894–1976)

His words reflect our enduring belief: Never mind Wall Street. Your own behavioral biases are often the greatest threat to your financial well-being. That's why behavioral investing should be integral to every family's investment process. Without it:

  • We get caught up in herd mentality, and leap before we look into exciting stock markets.
  • We are entrapped by loss aversion, and stay when we should go. 
  • We cringe at the very market risks that are expected to generate our greatest rewards All the while, we rush into financial markets, only to fret and regret our past performance long after the deed is done.

Why Do We Have Behavioral Biases?

Most of the behavioral biases that influence your investment decisions come from myriad mental shortcuts, based on behavioral traits we depend on to think more efficiently and act more effectively in our busy lives.

Usually (but not always!) these shortcuts work well for us. They can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we’re simply trying to stay afloat in the rushing roar of deliberations and decisions we face every day.

Behavioral Investing Biases

What Do Behavioral Biases Do to Us?

Our same survival-driven cognitive biases that are otherwise so helpful can turn deadly in investing. They overlap with one another, gang up on us, confuse us and contribute to multiple levels of damage done. And that's even before Wall Street gets ahold of us, preying on these important behavioral challenges to which they know the average investor is prone.  

Friend or foe, behavioral biases are a formidable force, imminently and over the long term. Even once you know they’re there, you’ll probably still  have a hard time overcoming them. It’s what your human mind does with the chemically induced instincts that fire off in your head long before your higher functions kick in. They trick us into wallowing in what financial author and neurologist William J. Bernstein, MD, PhD, describes as a “Petri dish of financially pathologic behavior,” including:

  • Counterproductive trading – incurring more trading expenses than are necessary, buying when prices are high and selling when they’re low.
  • Excessive risk-taking – rejecting the “risk insurance” that global diversification provides, instead over-concentrating in recent winners and abandoning recent losers.
  • Favoring emotions over evidence – disregarding decades of evidence-based advice on investment best practices.

What Can We Do About Them? 

To begin with, it helps to be familiar with the most common line-up of behavioral biases, so you can more readily recognize and defend against them the next time they’re threatening to derail your investment decisions.

Here are a few additional ways you can defend against the behaviorally biased enemy within:

Anchor your investing in a solid plan – By anchoring your trading activities in a carefully constructed plan (with predetermined asset allocations that reflect your personal goals and risk tolerances), you’ll stand a much better chance of overcoming the bias-driven distractions that rock your resolve along the way.

Increase your understanding – Don’t just take our word for it. Here is an entertaining and informative library on the fascinating relationship between your mind and your money:

Don’t go it alone – Just as you can’t see your face without the benefit of a mirror, your brain has a difficult time “seeing” its own biases. Hire an objective advisor affiliated with a reputable Registered Investment Advisor firm. Seek one who:

  • Is well-versed in behavioral finance
  • Is dedicated to serving your highest financial interests in a fiduciary relationship with you
  • Is not afraid to show you what you cannot see for yourself
  • Recommends mutual fund managers who exhibit similar traits in managing the mutual funds in which you invest.

This form of "second opinion" can be among your strongest defenses against all of your behavioral biases.

As you learn and explore, we hope you’ll discover: You may be unable to prevent your behavioral biases from staging attacks on your financial resolve. But, forewarned is forearmed. You stand a much better chance of thwarting them once you know they’re there!

Investing Biases To Be Aware Of

Bias

symptoms

damage

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 mean “safer” or “better.”

By over concentrating 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.

While you may be well-served to leap before you look at a snake, doing the same with your investments can bite you.

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 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

Everyone believes they’re above average. Clearly, not everyone can be correct on this statistical impossibility.

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 more painful to lose something if you’ve already invested time, energy, or money into it.

The past is past. Don’t let sunk cost fallacy stop you from unloading an existing holding once it no longer belongs in your 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.

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