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Behavioral Biases from A to Z: Overconfidence through Recency

April 10, 2018 View all posts by Atlas Wealth Advisors Atlas Wealth Advisors Behavior Bias, Investing

So far, we’ve discussed several biases that may influence your investment decisions and get in the way of reaching your financial goals. The nature of biases keeps us “in the dark” – we don’t think about them. Today we are going to shed some light on three more behavioral biases to help you make better financial decisions:

  • Overconfidence
  • Pattern recognition
  • Recency

Overconfidence

What is it?

When it comes to decision-making regarding our investments, some behavioral biases are like two sides of the same coin. We’ve seen that the fear bias can debilitate us, while its counterpart, greed, may also lead us to make rash decisions with unintended consequences.

Similarly, overconfidence is the alter ego to loss aversion. Overconfidence comes into play when we hold on to an investment for primarily emotional reasons, such as stock we’ve inherited or a wall street tech darling that we are sure will be the next Apple. Overconfidence allows us to place an emotional value on an investment, instead of taking a rational approach to evaluating performance or considering how an investment affects our overall portfolio and impacts our financial goals.

When is it helpful?

In his classic book, Your Money & Your Brain, Jason Zweig points out that overconfidence is at work in many parts of our lives, and is the norm, not the exception. He writes: “How else could we ever get up the nerve to ask somebody out on a date, go on a job interview, or compete in a sport?” He argues that people with “clinical depress[ion]” are the only “major group whose members do not consistently believe they are above average.”

When is it harmful?

Overconfidence can blur our financial vision, especially when interacting with other biases, such as greed, confirmation, and/or familiarity bias. This interaction can have us thinking we are above the odds because we believe, consciously or not, that we are luckier or smarter than average.

Overconfidence may hurt you when the consequences of those decisions derail you from your carefully crafted financial plan that is based on your own personal goals.

Pattern Recognition

What is it?

Since the beginning of time, our ancestors have depended on pattern recognition for survival. Is that a roaring stream or a roaring lion close by? Is that a rock formation or a snake by my leg?

Such patterns – of sound, sight, timing – need to be recognized quickly, and our brains are conditioned to do so. However, this impulse tends to overextend itself and we compulsively try to find patterns in even the most random events, such as ten coin-flips all coming out tails.

Zweig writes: “Just as nature abhors a vacuum, people hate randomness” because of our brain’s dopamine-induced “prediction addiction.” Las Vegas has this impulse to thank for much of its tourism industry.

When is it helpful?

If humanity had never developed pattern recognition, our history would have been very short. From stopping at red lights to a familiar shared look between partners, pattern recognition helps us through life every day. We even work out this impulse for pleasure to develop a skill in such pastimes as sudoku and Rubik’s cubes.

When is it harmful?

Zweig recently published a fascinating piece on how financial figures presented in red in lieu of black can make us more fearful and risk-averse. This illustrates vividly the power of pattern recognition, even if the “pattern” (red=danger, loss) has no deeper meaning in this case.

Is a suddenly-appearing pattern of financial news worth following or is it a short-lived illusion? Given how distracting and noisy the media covering the markets can be, we may benefit by focusing on our own long-term goals.

Recency

What is it?

Recency causes us to be distracted by recent experience over long-term circumstances. In Nudge, Nobel laureate Richard Thaler and co-author Cass Sunstein write about recency: “If floods have not occurred in the immediate past, people who live on floodplains are far less likely to purchase insurance.” Recency fools people into basing decisions on the lack of flooding rather than the reality that they live on a flood plain.

When is it helpful?

In his classic Stumbling on Happiness, Daniel Gilbert writes that we use recency to interpret ambiguous situations in their immediate context. If someone opines, “That was a nice drive,” on a golf course, that means one thing. If you’re driving down the coast on a bright blue day, “nice drive” means something else.

When is it harmful?

When we let recency steer the ship rather than taking the wheel with more rational, evidence-based wisdom. Buying high and selling low is not likely to be a part of anyone’s strategy. Yet no matter how often and how quickly the market goes through its bear and bull cycles, recency causes many investors to lose big every time.

When we make decisions based on knee-jerk reactions instead of following our thoughtfully crafted financial plans, we may very well end up buying high on the crest of the wave and later selling low too quickly in the troughs.

We’re near the end of our enlightening journey through Behavioral Biases, A to Z. Stay tuned for the next installment in this series!

 

Read the Previous Posts in this Series

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