All humans possess psychological biases. And when it comes to money and investing, sometimes those psychological biases influence us in such a way that we unknowingly make illogical decisions.
In the 2001 study “Quantitative Analysis of Investor Behavior” released by Dalbar, a financial-services research firm, it was concluded that the average investor failed to achieve market-index returns. In a 17-year period the S&P 500 returned an average of 16.29% per year, while the typical equity investor achieved only 5.32% for the same period.
Results from the fixed income side of the markets had similar results with the average investor getting just a 6.08% return, while the long-term Government Bond Index returned 11.83%. In the 2015 version of the same study, Dalbar similarly concluded “the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%. The broader market return was more than double the average equity mutual fund investor’s return (13.69% vs. 5.50%).”
Behavioral Finance uses psychology-based theories to explain stock market anomalies for the purpose of identifying and understanding why people make the financial choices they do. A psychological bias is defined as “the tendency to make decisions or take action in an unknowingly illogical way.” Simply put, psychological bias is the opposite of common sense and clear, measured judgment — thus, it can lead to missed opportunities and poor decision-making. Our psychological biases allow our brains to take short cuts in our thinking, and while they have their practical purpose in nature, they can frequently lead to irrational investment decisions.
As a financial investor, understanding your psychological biases might help you be more aware of your own decision-making process in the future. Granted, it is hard to spot psychological biases in ourselves, because it often comes from subconscious thinking. But making you aware of how they influence you is the first step.
Because there are more than 100 identified decision-making, belief, and behavioral biases (just Google “list of cognitive biases”), we cannot explore them all in this blog. But we can draw your attention to the four key biases that often affect investors and their decisions: Herd Behavior, Mental Accounting, Anchoring, and High Self-Rating.
- Herd behavior states that people tend to mimic the financial behaviors of the majority or herd. The herd instinct leads people to follow popular trends without any deep thought of their own. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. The herd instinct is correlated closely with the “empathy gap,” which is an inability to make rational decisions under emotional strains, such as anxiety, anger or excitement.
- Mental Accounting is the tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behavior more than the events themselves. For example, you decide to go to the theater and tickets are $20 each. When you arrive at the theater you realize you have lost a $20 bill. Do you buy a $20 ticket for the show anyway? Studies indicate roughly 88% of people in this situation would buy the ticket. Now, let’s say you paid for the $20 ticket in advance. When you arrive at the theater, you realize your ticket is at home. Would you pay $20 to purchase another? Only 40% of respondents in this scenario say they would buy another ticket. Notice, however, that in both scenarios you’re out $40 — different scenario, same amount of money, but different mental compartments result in different outcomes.
- Anchoring refers to attaching a spending level to a certain reference, such as spending more money on what is perceived to be a better item of clothing. This bias is the tendency to jump to conclusions — that is, to base your final judgment on information gained early in the decision-making process. Think of this as a “first impression” bias. Once you form an initial picture of a situation, it’s hard to see other possibilities. A related bias is the Over-Reacting/Under-Reacting Bias. Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring or placing too much importance on recent events while ignoring historical data, is an over- or under-reaction to market events, which results in prices falling too much on bad news and rising too much on good news.
- High Self-rating refers to a person’s tendency to rank himself better than others or higher than an average person. For example, an investor may think that he is an investment guru when his investment performs optimally but will dismiss his contributions to an investment performing poorly. This thought process may lead an investor to be overconfident and make bad decisions in a current market because his decisions turned out well in a previous situation. There is absolutely no real correlation between the two scenarios, only the investor bias (belief) that once right, always right.
Many behaviorists will argue that investors often behave irrationally, producing inefficient markets and mispriced securities. It has also been said that investors can be their own worst enemies. One of the most important roles of a financial advisor, therefore, is to manage a client’s emotions in times of volatility, to educate and coach them to make sure they understand and are well prepared to handle the bull rides up and the swift drops down. Trying to outguess the market doesn’t pay off over the long term. In fact, it often results in irrational behavior, not to mention a dent in your wealth.
To overcome psychological biases, look for ways to introduce objectivity into your decision-making, and allow more time for decisions. Use tools that help you assess background information systematically, surround yourself with people who will challenge your opinions, and listen carefully and empathetically to their views — even when they tell you something you don’t want to hear.
As Daniel Kahneman, Dan Lovallo, and Oliver Sibony suggest in a 2011 Harvard Business Review article, important decisions subjected to biased-thinking would be better made by a group than an individual. This is where your financial advising team can add value beyond just portfolio design. Talking with them, listening to them, and making sound decisions through group-thinking can help prevent future regret from emotional buying or selling.