Welcome to the next instalment in our series of evidence-based investment insights; Behavioural biases – What makes your brain tick? To check out the rest of the series, click here.
In our last piece, The human factor in evidence-based investing, we explored how our deep-seated ‘fight or flight’ instincts generate an array of behavioural biases that trick us into making significant money-management mistakes. In this instalment, we’ll familiarise you with a half-dozen of these more potent biases, and how you can avoid sabotaging your own best-laid, investment plans by recognising the signs of a behavioural booby trap.
Behavioural 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 we covered 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.
Behavioural 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 our 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 harbour’ (or vice-versa when bull markets are on a tear).
Behavioural bias #3: Confirmation bias
Confirmation bias is the tendency to favour 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 behavioural biases on this and other lists, confirmation bias may be the greatest reason why the rigorous, peer-reviewed approach we 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.
Behavioural 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 we 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.
Behavioural 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.
Behavioural 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 behavioural biases, with many more worth exploring in Zweig’s and others’ books on behavioural finance. We recommend 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 behavioural 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 we suggest working with an objective adviser, to help you see and avoid collisions with yourself that your own myopic vision might miss.
Continue exploring the rest of the evidence-based investment insights here.
