Behavioral Finance: Exploring our Biases
That which I would not, that do I do!
Whether you are investing your assets or putting together an overall financial plan, you are continuously faced with an onslaught of never-ending decisions. There are many points along this journey when we look back and wonder “what was I thinking?!” Often, hindsight brings us clarity and we (hopefully) learn from the experience. Other times, we just don’t have a foggy clue as to why we did what we did.
There is a very fascinating area of study called Behavioral Finance that addresses these conundrums. Time after time I have seen extremely intelligent people make mind-boggling and irrational decisions when it comes to their money. One of the main precepts in the study of behavioral finance are biases. These financial behavioral biases have been identified over the years and when reading through them, we all might feel a bit of a “tail between the legs’ effect. Let’s pick apart a few of the more popular biases and see if we can find one or two that might make ‘a friend’ feel uncomfortable:
“Anchoring” or Confirmation Bias
Ever go to a highly recommended restaurant for the first time and something was not great about your dinner and you left disappointed? Then later, a friend suggests meeting for lunch at this place and you reluctantly go back only to find something wrong with the whole experience again: Your server was rude, never refilled your drinks, etc. That’s it…I’m never coming back to this place, it’s terrible!! Never mind that the first time you went, there was a new line cook who totally spaced on a crucial ingredient and the disappointing server had just found out her grandmother died.
You no longer care that this restaurant gets rave reviews; you “know” it stinks. It’s hard to shake off first impressions and you will always come in skewed on your second impression because you are looking for evidence to confirm your original opinion.
Before you think this one doesn’t apply to you, think about your particular political affiliation. Ever wonder why every news story you watch on TV and every Facebook rant on your feed just seems to confirm your opinions and what you know to be true?
Disposition Effect Bias
This one refers to placing a label on investments as winners or losers. This can happen from owning an investment for a long time and realizing that is has made you a lot of money and therefore you never want to get rid of it…never mind that pretty much any security that you would have owned for that long would have made you about the same amount or even more.
A very common misperception that after looking back at what happened, it was obviously predictable and completely avoidable…although nobody else on the planet caught it either and there was really no way you could have seen it coming.
You just don’t want to leave your own backyard because you know it and you feel safe there. Skip the diversification, just give me what I know.
Here is one that I really get a kick out of:
Everything good that happens is because I’m brilliant and everything bad that happens is because some outside factor unfolded that I couldn’t control.
Remember the last time a friend of yours came back from Vegas and you asked them how they did? They either say “oh, I came out about even” or they will go on about the $200 bucks they won on a Wheel of Fortune slot machine jackpot, but they somehow forget to mention the $4,000 they left at the Craps table.
Or even better – The financial “Guru” sitting in the cubicle next to you at the office who is constantly online changing their 401K allocations and bragging about how they have been killing it and making truckloads of cash. At first, you feel like a loser because you aren’t raking in the dough like they are, but then you realize that they are 84 years old and still sitting in that cubicle.
Feeling uncomfortable yet? Great, let’s keep going.
Trend Chasing Bias
This is a biggie- I probably see this one the most often. Behavioral finance research has shown that 39% of all new money going into mutual funds went into the 10% of funds with the best performance the previous year. And in almost every case, that same performance fails to continue. You know that standard disclaimer underneath every advertisement for any mutual fund or investment product in which they post their returns – “Past performance is not indicative of future results” …yea, nobody else reads that either. This one should come with its own soundtrack by Carole King, “It’s Too Late Baby, Now it’s too late.”
I can’t tell you how many times I’ve had the request to sell all those holdings that have been losing money and buy more of those that have been doing really well. After an hour of going back over the concept of Buying Low and Selling High, I am then met with a blank stare and the question “So, can we dump the losers and buy more of the winners?” (Insert egregious head-slap here.)
We interrupt this broadcast for two obligatory Warren Buffet Quotes:
“Buy when others are fearful and sell when others are confident”
“Bad markets are when stocks return to their rightful owners.”
Can’t get off this soapbox just yet. This is the one that almost makes me lose my salvation. “I quit contributing to my 401k because the market is so bad.” (Skip the next head-slap and just get me a ball-peen hammer!) You must realize that this is the same as driving up to the gas pump when gas costs $2 per gallon and saying, no way…I’m waiting till it’s back up to $4 a gallon before I fill my tank!
And for the last one, I’ll cool off a bit because I can be more sympathetic about this one.
Regret Aversion Bias (closely related to the Worry Bias)
This bias can be best illustrated by an ostrich with their head in the sand. We’ve made a mistake or two…or an unbelievable plethora of mistakes, and now we don’t want to realize it or face it or deal with it or remember it. I’m just going to go over here and bury my head in the sand with my rear-end up so passer byes will have a place to park their bike.
This realization usually comes with a heavy dose of shame, frustration, fear and even anger. When was the last time you made a good decision when you were afraid, ashamed or angry? But, possibly even worse than making bad decisions is making no decision at all. The opportunity cost of employing the ‘Ostrich Strategy’ can be devastating.
Now that we are all sitting in the corner with our own personal Dunce caps, how do we fix this?
- Change the channel and watch Andy Griffith re-runs instead. Realize that the Media (all forms) has a huge impact on your perceptions and can easily drive your decision-making process. It shouldn’t.
- Today’s Gurus are tomorrow’s idiots. Don’t try to guess the timing of the market or follow someone claiming to know the future. Systematically and methodically rebalance your portfolios as the market moves up and down and take the emotional knee-jerking out of the picture.
- I know I’m right…or not. Be willing to check yourself and make sure your pre-conceived notions are not affecting your perception of the situation.
- Rip out your rear-view mirror. With the exception of learning from our mistakes, the past is worthless.
- Mullets and parachute pants aren’t cool anymore. If you are hell-bent on chasing trends, then just follow your kids’/grandkids’ Instagram account. You will at least be up to date on the current texting acronyms.
- Assume the downward dog. Stop kicking yourself, don’t let the shame of your past mistakes drive your future. Sign up for a Yoga class, take a deep breath, seek wise counsel, and realize your best days haven’t happened yet!
So, the next time you are on vacation and you see a couple of gray-haired ostriches holding hands, walking down a beach with a beautiful sunset in the background…you’ll know they figured it out.
(Oh, and regarding that Harvard School of Business study about the two groups…I made that whole thing up to prove my last point…don’t believe everything you read online. 😊)