The Guide To Non-Biased Behavioral Investing
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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:
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.
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:
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:
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!
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.”
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)
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 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.
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.
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.
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.
“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.
“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.
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.
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.
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.
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
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.
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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