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Behavioral Bias A to Z: Conclusion

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We’ll end today where we started, with our original premise:  Behavioral bias in finance can have disastrous and costly consequences. Knowing ourselves and having an outside advisor can be essential to seeing through your biases.

As we have seen, this statement can play out in a several ways, some of them more detrimental than others. Our fight-or-flight brains may need a healthy dose of awareness or outside counsel to keep us from becoming saboteurs to our own financial journey.

Behavioral Finance in Our Lives

Just as we would look to academic findings to guide many complex decisions we have to make, we may benefit from looking to behavioral finance scholars to see our behavioral biases coming and defend ourselves when they interfere with our financial plans.

If it the financial consequences weren’t so potentially disastrous, behavioral finance would be a purely academic field. But given how often our less-than-rational reactions can damage our carefully crafted investment plans, an ounce of preventative awareness may be worth the proverbial pound of cure. To that end, here’s a summary of the biases we’ve covered:

Behavioral Biases A-F

The Bias Its Symptoms How it Appears
Anchoring Fixing decisions too strongly on a point of reference, valid or not.  “Last year this stock was worth twice what it is now. I’ll wait until it goes back up to sell.”
Blind Spot The plank in our own eye. When we can quickly, even accurately, spot the biases of others, yet 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 In this bias, we favor the facts that go with what we already believe and ignore those that don’t. After our initial reaction, we may find confirmation that isn’t there, even if a change of course would be the most rational move.
Familiarity We gravitate toward the familiar, and avoid the unknown. Global diversification may help to managing risk, and familiarity bias directly opposes this strategy.
Fear Our first reaction to a bear market, or even one that just appears to be, is often panic. “We'd never buy a shirt for full price then be O.K. returning it in exchange for the sale price. ‘Scary’ markets convince people this unequal exchange makes sense.” (Carl Richards)
Framing 90% fat-free or 10% fat? Re-framing the same information can distract us from our financial plan. Narrow framing can put blinders on us, causing us to see the right information in the wrong way, rather than in the comprehensive view of our whole portfolio.

 

Behavioral Biases G - O

The Bias Its Symptoms How it Appears
Greed Chasing after returns, without considering any other factors that might help us make well-informed financial decisions. Chasing after short-term investment trends may leave us out of synch with our long-term financial plans.
Herd Mentality “If everyone was walking off a cliff, would you?” Our mother’s proverbial question can ring truer than we care to admit, even when it comes to our finances. Greed and fear reactions to financial events can be exacerbated by herd mentality when we fail to consider our own financial goals.
Hindsight I knew it all along. Looking back after the fact to see ourselves having insights and predictions even though we may not have. This bias can contribute to a “gut instinct” in the future that’s based on our own incorrect view of the past.
Loss Aversion We fear losing more than we love winning. We react strongly against risk of losing, even when the chances of winning are better. Loss aversion causes us to stay entirely off the field, even when a sound victory is not only possible, but likely. Despite evidence that now is time to act, our aversion to loss tells us to remain withdrawn.
Mental Accounting Mental accounting differentiates between certain ‘kinds’ of money, even if the amounts are the same.

 

We might hold onto an inheritance and blow through some lottery winnings, even if they are both the same amount. Mental accounting can trick us into treating the same cash differently.
Outcome Our biased brains have a tendency to see skill where it wasn’t, even in the case of pure, blind luck. If we see an outcome, good or bad, as the result of foresight we didn’t really have, it may unduly influence our future decisions regarding our investments.
Overconfidence The “Lake Wobegon effect”—overconfidence can have everyone thinking they are “above average.”

 

Overconfidence might have us believing that we’ve got the “special sauce” no one else does even when our results don’t support that conclusion.

 

Behavioral Bias P - Z

The Bias Its Symptoms How it Appears
Pattern Recognition Our born-in survival instinct is to see predictive patterns, even if they aren’t there. We’ve been conditioned by evolution to detect patterns and seeing these in random market fluctuations may lead us to make decisions based on evidence we think we see but cannot validate.
Recency What just happened? Recent events may have a strong influence, even when we plan with the long view. If we constantly chase after or run away from the most recent market behavior, we may end up losing sight of the big picture as it pertains to our own financial goals.
Sunk Cost Fallacy Throwing good money after bad. We become attached, even to a bad idea, if we’ve already invested money, time, and energy in it. Even when we are losing on an investment, sunk cost fallacy can keep us holding onto it for all the wrong reasons.
Tracking Error Regret Keeping up with those Joneses. When we measure ourselves against our neighbor’s seemingly greener grass. It can be unnecessarily upsetting to compare our long-term financial plans to the short-term results of others.

 

Next Steps: Think Slow

Even after raising our awareness about the behavioral biases that can distract us, the intense emotions of fear, greed, doubt and recklessness will tempt us to react.

In Thinking, Fast and Slow, Daniel Kahneman writes that 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 short, we are often at the mercy of System 1.  When we think this “fast” way, our instincts are foregrounded and often have the last word.

Again, we would recommend an outside advisor who can help us move past System 1 thinking into more intentional, clear-headed decisions that fit within our long-term plan.

Investors of “Ordinary Intelligence”

Berkshire Hathaway Chairman and CEO Warren Buffet is not a behavioral economist, but he is a businessman who has a way with words. We’ll end with one of his memorable quotes:

“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.”

His experience-tested wisdom will help us immensely, especially when cultivating awareness of financial instincts.  But if you need some help “seeing around corner” when it comes to behavioral bias, give us a call—sometimes two pairs of eyes are better than one.

There are no guarantees that investment strategies will be successful. Diversification does not ensure or protect against loss in declining markets. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision.