In wrapping up this series, The ABCs of Behavioral Biases, it's time to remember the original premise: Your own behavioral biases are often the greatest threat to your financial well-being. You've seen the many ways this single statement can play out, and how often our survival-mode brains trick us into making financial calls that foil our own best interests.
As academic evidence guides disciplined investment strategy, turning to the work of behavioral finance scholars allows us to understand and employ effective defenses against our most aggressive behavioral biases.
If there weren’t so much damage done, behavioral finance might be of merely academic interest. But given how often – and in how many ways – your fight-or-flight instincts collide with your rational investment plans, it’s worth being aware of the tell-tale signs, so you can detect when a behavioral bias may be running roughshod over your higher reasoning. To help with that, here’s a summary of the biases that have been covered throughout this series:
A Behavioral Bias Overview
| The Bias | Its Symptoms | The Damage Done |
| Anchoring | Going down with the proverbial ship by fixing on rules of thumb or references that don’t serve your best interests. | “I paid $11/share for this stock and now it’s only worth $9. I won’t sell it until I’ve broken even.” |
| Blind Spot | The mirror might lie after all. We can assess others’ behavioral biases, but we often remain blind to our own. | “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Daniel Kahneman) |
| Confirmation | This “I thought so” bias causes you to seek news that supports your beliefs and ignore conflicting evidence. | After forming initial reactions, we’ll ignore new facts and find false affirmations to justify our chosen course … even if it would be in our best financial interest to consider a change. |
| Familiarity | Familiarity breeds complacency. We forget that “familiar” doesn’t always mean “safer” or “better.” | By overconcentrating in familiar assets (domestic vs. foreign, or a company stock) you decrease global diversification and increase your exposure to unnecessary market risks. |
| Fear | Financial fear is that “Get me out, NOW” panic we feel whenever the markets turn brutal. | While you may be well-served to leap before you look at a snake, doing the same with your investments can bite you. |
| Framing | Six of one or half a dozen of another? Different ways of considering the same information can lead to illogically different conclusions. | Narrow framing can trick you into chasing or fleeing individual holdings, instead of managing everything you hold within the greater framework of your portfolio. |
| Greed | Excitement is an investor’s enemy (to paraphrase Warren Buffett). | You can get burned in high-flying markets if you forget what really counts: managing risks, controlling costs, and sticking to plan. |
| Herd Mentality | “If everyone jumped off a bridge …” Your mother was right. Even if “everyone is doing it,” that doesn’t mean you should. | Herd mentality intensifies our greedy or fearful financial reactions to the random events that generated the excitement to begin with. |
| Hindsight | “I knew it all along” (even if you didn’t). When your hindsight isn’t 20/20, your brain may subtly shift it until it is. | If you trust your “gut” instead of a disciplined investment strategy, you may be hitching your financial future to a skewed view of the past. |
| Loss Aversion | No pain is even better than a gain. We humans are hardwired to abhor losing even more than we crave winning. | Loss aversion causes investors to try to dodge bear markets, despite overwhelming evidence that market-timing is more likely to increase costs and decrease expected returns. |
| Mental Accounting | Not all money is created equal. Mental accounting assigns different values to different dollars – such as inherited assets vs. lottery wins. | Reluctant to sell an inherited holding? Want to blow a windfall as “fun money”? Mental accounting can play against you if you let it overrule your best financial interests. |
| Outcome | Luck or skill? Even when an outcome is just random luck, your biased brain still may attribute it to special skills. | If you misattribute good or bad investment outcomes to a foresight you couldn’t possibly have had, it imperils your ability to remain an objective investor for the long haul. |
| Overconfidence | Everyone believes they’re above average. Clearly, not everyone can be correct on this statistical impossibility. | Overconfidence puffs up your belief that you’ve got the rare luck or skill required to consistently “beat” the market, instead of patiently participating in its long-term returns. |
| Pattern Recognition | Looks can deceive. Our survival instincts strongly bias us toward finding predictive patterns, even in a random series. | By being predisposed to mistake random market runs as reliable patterns, investors are often left chasing expensive mirages. |
| Recency | Out of sight, out of mind. We tend to let recent events most heavily influence us, even for our long-range planning. | If you chase or flee the market’s most recent returns, you’ll end up piling into high-priced hot holdings and selling low during the downturns. |
| Sunk Cost Fallacy | Throwing good money after bad. It’s more painful to lose something if you’ve already invested time, energy, or money into it. | The past is past. Don’t let sunk cost fallacy stop you from unloading an existing holding once it no longer belongs in your portfolio. |
| Tracking Error Regret | Shoulda, coulda, woulda. Tracking error regret happens when you compare yourself to external standards and wish you were more like them. | It can be deeply damaging to your investment returns if you compare your own performance against apples-to-oranges measures, and then trade in reaction to the mismatched numbers. |
Next Steps: Think Slow
Even once you’re familiar with the behavioral biases that stand between you and clear-heading thinking, you’ll probably still be routinely tempted to react to the fear, greed, doubt, recklessness, and similar hot emotions.
Nobel laureate Daniel Kahneman helps us understand why in his book, “Thinking, Fast and Slow,” where he describes how we engage in System 1 (fast) and System 2 (slow) thinking: “In the picture that emerges from recent research, the intuitive System 1 is more influential than your experience tells you, and it is the secret author of many of the choices and judgments you make.”
In other words, we can’t help ourselves. When we think fast, our instincts tend to run the show; for better or worse, they’re the first thoughts that come to mind.
This is one reason an objective advisor can be such a critical ally, helping you move past your System 1 thinking into more deliberate decision-making for your long-term goals. (On the flip side, financial providers who are themselves fixated on picking hot stocks or timing the market on your behalf are more likely to exacerbate than alleviate your most dangerous biases.)
Investors of “Ordinary Intelligence”
Berkshire Hathaway Chairman and CEO Warren Buffett is a businessman, not a behavioral economist. But he does have a way with words, including this bit of his timeless wisdom:
“Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
If you can remember this cool-headed thinking the next time you’re tempted to act on your investment instincts, Mr. Buffett’s got nothing on you (except perhaps a few billion dollars). But if you could use some help managing the behavioral biases that are likely lurking in your blind spot, feel free to...
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as investment, tax, or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Digital assets and cryptocurrencies are highly volatile and could present an increased risk to an investors portfolio. The future of digital assets and cryptocurrencies is uncertain and highly speculative and should be considered only by investors willing and able to take on the risk and potentially endure substantial loss. Nothing in this content is to be considered advice to purchase or invest in digital assets or cryptocurrencies.
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