Broker Check

Behavioral Finance Part Two

January 11, 2021

Part II

The Flawed Investor

Let's agree that humans are flawed and our thinking is flawed. Let's further agree that we are rarely completely rational. Now that we've accepted our own human frailty, let's discuss the nature of these frailties and how they can cause us to make poor decisions.

Hindsight Bias, or "I knew it all along!"

This is the impulse for a person to believe that they saw "it" coming all along - whatever "it" may have been or how unpredictable "it" was. This is a flaw in how we are wired, because it is easier for us to grasp what actually happened vs. the myriad of other possible outcomes that didn't happen. It's also uncomfortable for us to admit that we were caught off guard.

Those who suffer from hindsight bias also tend to be overconfident. After all, if a person believes they called that last market sell-off, what's to say they won't call the next one? And if they can call the next one, it's ok to load up on risk because they'll be able to get out in time. The fact is, they didn't call the last one, and they won't call the next one - and they'll likely live to regret taking on that extra risk.

Self-Attribution Bias, or "I'm just a naturally talented investor."

This bias allows a person to attribute their successes to innate aspects of themselves ("I'm successful in my career because I'm a hard worker") and failures to external factors ("My blood pressure is too high because my job is stressful").

If each investing failure a person experiences is never their fault and each success they experience is because they're innately great at investing, a person will never learn how to make good decisions. We see this bias most often during long periods of prosperity where all that's needed to make money in the stock market is buying something (anything), because everything is going up, up, up. If at the start of a multi-year stock market rally someone bought a mutual fund that did really well for several years, they may have believed that it was their mutual-fund-picking prowess that got those results. When that same rally inevitably runs out of steam, they may have cursed their bad luck or blamed the mutual fund manager for being a bad stock picker. But they didn't learn anything about how to pick a good investment and will continue to make sub-optimal choices.

Recency Bias, or "This party is never going to end!"

Recency bias causes us to believe that whatever is happening now will continue to happen forever. Think back to late 2019 and early 2020. At that time, markets had been enjoying relatively low volatility, marching steadily upward month after month with very few pauses. Investors found themselves lulled into a false sense of security. But by March 2020, we had experienced the fastest Bear Market in history and investors were panicking. When I talked with clients during this period, they overwhelmingly indicated a belief that the market, which had steadily risen for nearly a decade, would keep falling until there was nothing left in their 401(k)s.

In my mind, this is the single most dangerous error an investor faces. It can cause greed in good times and panic selling in bad times. If you take nothing else away from this article, take this lesson: nothing goes on forever.

Loss Aversion, or "I need more reward for this risk."

In general, we dislike losing much more than we like gaining. That is, we fear the pain of loss much more than we enjoy achieving gains. This causes investors to distort risk-return dynamics in their minds. A client may tell me that they want the opportunity to earn a return of 8.5% on average each year, but they're not willing to accept the fact that they might lose up to 50% of their account value in a bad year. The fact is investments that return 8.5% on average each year must carry this risk of loss. Without the risk of loss, there can be no upside risk of gain. Like they say: no pain, no gain.

Read: Risk Tolerance: What Is It? Why Does It Matter?

Dwelling excessively on avoiding risk can deprive a client of years of gains and compounding, and it makes choosing a portfolio of investments needlessly difficult. It can also cloud an investor's thinking when it comes time to sell a losing investment.

Regret Aversion Bias, or "What if I choose the wrong thing?"

This is the tendency for an individual to avoid making a choice because they fear making the wrong choice - they fear regret. Investors will sometimes avoid making a purchase (or more often selling a position) because they are afraid they will have made the wrong decision on doing so. Even if there is objective evidence that the transaction is to their benefit, an investor may still dither in making a move.

Having discipline around portfolio management is one very important piece of the investing success puzzle. Regret Aversion corrodes discipline and clouds judgment.

Bandwagon Effect, or "Everyone else is doing it."

"If all your friends were jumping off the Brooklyn Bridge, would you do it to?" Most of us heard some version of this question from a parent during childhood - most likely right after we pleaded, "But everyone else is doing it!" People will sometimes do something primarily because they see other people, in large numbers, doing it.

The Bandwagon Effect isn't always bad. For example, this phenomenon is part of why the ALS Ice Bucket Challenge took off back in 2014. By some estimates, over $200 million was raised worldwide for research as a result of this challenge's popularity. But there is a dark side. As an investor, if you see lots of other investors buying a particular stock or type of stock, you may be tempted to buy in, too - even if there is no evidence that such a purchase benefits you or fits your needs and goals. The Bandwagon Effect is, in part, how asset bubbles form. Investors crowd into a small part of the market, drive up prices beyond what is sustainable, and when the bubble bursts, the latecomers are left holding the bag.

So, if every investor is flawed and can fall prey to errors and biases, how do we cope?

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Come back next week for Part III