Behavioral Biases – What Makes Your Brain Trick?

Welcome to the next installment in our series of Escient Financial's Evidence-Based Investment Insights: Behavioral Biases – What Makes Your Brain Trick?

The last piece, “The Human Factor in Evidence-Based Investing,” explored how our deep-seated “fight or flight” instincts generate an array of behavioral biases that trick us into making significant money-management mistakes. Now, it's time to familiarize you with a half-dozen of these more potent biases, and how you can avoid sabotaging your own best-laid, investment plans by recognizing the signs of a behavioral booby trap. This is a brief overview of Behavioral Biases. For a more detailed insight, check out our previous Behavioral Biases series.

Behavioral Bias #1: Herd Mentality

Herd mentality is what happens to you when you see a market movement afoot and you conclude that you had best join the stampede. The herd may be hurtling toward what seems like a hot buying opportunity, such as a run on a stock or stock market sector. Or it may be fleeing a widely perceived risk, such as a country in economic turmoil. Either way, as wascovered in “Ignoring the Siren Song of Daily Market Pricing,” following the herd puts you on a dangerous path toward buying high, selling low and incurring unnecessary expenses en route.

Behavioral Bias #2: Recency

Even without a herd to speed your way, your long-term plans are at risk when you succumb to the tendency to give recent information greater weight than the long-term evidence warrants. From an earlier piece, “The Business of Investing,” we know that stocks have historically delivered premium returns over bonds. And yet, whenever stock markets dip downward, we typically see recency at play, as droves of investors sell their stocks to seek “safe harbor” (or vice-versa when bull markets on a tear).

Behavioral Bias #3: Confirmation Bias

Confirmation bias is the tendency to favor evidence that supports our beliefs and gloss over that which refutes it. We’ll notice and watch news shows that support our belief structure; we’ll skip over those that would require us to radically change our views if we are proven wrong. Of all the behavioral biases on this and other lists, confirmation bias may be the greatest reason why the rigorous, peer-reviewed approach described in “The Essence of Evidence-Based Investing” becomes so critical to objective decision-making. Without it, our minds want us to be right so badly, that they will rig the game for us, but against our best interests as investors.

Behavioral Bias #4: Overconfidence

In “Your Money Your Brain,” Jason Zweig describes overconfidence in action when he asks: “How else could we ever get up the nerve to ask somebody out on a date, go on a job interview, or compete in a sport?” In these and similar scenarios, a degree of overconfidence can be beneficial. But it often becomes dangerous in investing. It tricks us into believing we can consistently beat the market by being smarter or luckier than average. In reality, as was described in “You, the Market, and the Prices You Pay,” it’s best to patiently participate in the market’s expected returns, instead of trying to go for broke – potentially literally.

Behavioral Bias #5: Loss Aversion

As a flip side to overconfidence, we also are endowed with an over-sized dose of loss aversion, which means we are significantly more pained by the thought of losing wealth than we are excited by the prospect of gaining it. As Zweig states, “Doing anything – or even thinking about doing anything – that could lead to an inescapable loss is extremely painful.”

One way that loss aversion plays out is when investors prefer to sit in cash or bonds during bear markets – or even when stocks are going up, but a correction seems overdue. The evidence clearly demonstrates that you are likely to end up with higher long-term returns by at least staying put, if not bulking up on stocks while they are “cheap.” And yet, even the potential for future loss can be a more compelling emotional stimulus than the likelihood of long-term returns.

Behavioral Bias #6: Sunken Costs

We investors also have a terrible time admitting defeat. When we buy an investment and it sinks lower, we tell ourselves we don’t want to sell until it’s at least back to what we paid. In a data-driven strategy (and life in general), the evidence is strong that this sort of sunken-cost logic leads people to throw good money after bad. By refusing to let go of past losses – or gains – that no longer suit your portfolio’s purposes, an otherwise solid investment strategy becomes clouded by emotional choices and debilitating distractions.

Your Take-Home

So there you have it. Six behavioral biases, with many more worth exploring in Zweig’s and others’ books on behavioral finance. It's recommended you do take the time to learn more. First, it’s a fascinating field of inquiry. Second, it can help you become a more confident investor. As a bonus, the insights are likely to enhance other aspects of your life as well.

But be forewarned. Even once you are aware of your behavioral stumbling blocks, it can still be devilishly difficult to avoid tripping on them as they fire off lightning-fast reactions in your brain well before your logic has any say. That’s why it's suggested to work with an objective advisor, to help you see and avoid collisions with yourself that your own myopic vision might miss.

The next and final installment of Escient Financial’s series on Evidence Based Investment Insights will tie together the insights shared throughout the series. Of course there’s no need to stand on ceremony. If you have questions or ideas you’d like to explore right away, feel free to reach out or...