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Investment 101: Part 12 – What Makes Your Brain Trick?

By on October 9, 2014
Categories: INVESTING

In our last piece, “Investment 101: Part 11 – The Human Factor in Evidence-Based Investing” we explored how our deep-seated “fight or flight” instincts generate an array of behavioral biases that trick us into making significant money-management mistakes. In this installment, we’ll 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.

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 we covered in “Investment 101:  Part 2 – 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 our earlier piece, “Investment 101:  Part 7 – What Drives Market Returns?” 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 are 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 we described in “Investment 101:  Part 8 – 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

Garrison Keillor made overconfidence famous in his monologue about Lake Wobegon, “where all the women are strong, all the men are good looking, and all the children are above average.” Keillor’s gentle jab actually reflects reams of data indicating that most people (especially men) believe that their acumen is above average. On a homespun radio show, impossible overconfidence is quaint. In investing, it’s dangerous. It tricks us into losing sight of the fact that investors cannot expect to consistently outsmart the collective wisdom of the market (as we described in “Investment 101:  Part 1 – You, the Market and the Prices You Pay”), especially after the costs involved.

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 Jason Zweig of “Your Money and Your Brain” 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:  Sunk 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 sunk-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.  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 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 we suggest working with an objective advisor, to help you see and avoid collisions with yourself that your own myopic vision might miss.

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