Cognitive or Psychological Biases are our brain’s natural way of helping us simplify our decision-making process. While often they are the result of ways in which our brains have adapted to make us more efficient, they can be detrimental as well, especially to our investments. There are many cognitive biases we could cover. To get us started, we have decided to focus on three; Endowment Bias, Loss Aversion Bias, and Anchoring Bias. (UPDATE: we’ve added three more: Overconfidence, Familiarity, and the Gambler’s Fallacy). Though biases are a natural cognitive process, being aware of them can help you limit the unfavorable impact they can have on your investor behaviors.
To set the tone, ask yourself this, Are you a long-term investor? More than likely you nodded your head yes. Great! Now let me ask you this: have you checked your account statements today? Yesterday? This week? Maybe this month? We are inherently trained to pull out our phones and check our account balances often. Far more often than a “long-term investor” would need to. And what does that cause? An almost impulsive desire to adjust our investments before they’ve been given the time they need to perform in our favor. Our desire to closely watch the market and the performance of our investments, leads to irrational investor behavior often influenced by Cognitive Biases. Additionally, due to recent volatility in the market we are all at an increased risk to act on these biases.
- Endowment Bias - We tend to assign greater value to an investment we already own.
Example- Richard Thaler and Daniel Kahneman, behavioral psychologists, performed a study with college undergrads which helps illustrate this point. First, they gave brand new coffee mugs to half the class while leaving the rest of the students empty handed. Next, they went about trying to set market prices for the coffee cups through a series of negotiations. They found that those doing the selling wouldn’t part ways with their new cups for anything less than $5.25 while those who didn’t have the cups wouldn’t pay more than $2.75 or so for a new mug. This idea — called the “Endowment effect” — stems from the fact that we humans are loss averse. We place a higher value on something we currently own or possess. Once something comes into our possession it’s tough to think about its value in a rational manner.If the endowment effect applies to coffee cups, it surely applies to stocks. The danger is that “we become fond of what we own – to a level where our selling price floats above what reasonable buyers are willing to pay”.
- Loss Aversion Bias - We are more motivated by our fears than by our aspirations.
Example- Loss aversion shows that the pain from losing money is twice as bad as the pleasure from making money. Investors are more erratic during market sell-offs. How do you overcome Loss Aversion Bias? Let’s say you have a stock or stocks in your portfolio that are at a loss right now - below your purchase price. Imagine your portfolio took the “Overnight Test.” Imagine that your investment portfolio somehow got liquidated overnight. So, when you wake up your holding 100% in cash. If you were given the opportunity to buy back into the market at no cost or tax implications, would you re-create the same portfolio that you’re currently holding – even buying the stocks that are at a loss?
- Anchoring Bias - When buying individual stocks, investors anchor themselves to the previous purchase price of the stock.
Example- The first thing investors do when researching a stock, is review the historical chart showing the pattern of past stock prices. The fact that a company traded for a certain price in the past gives an investor a false sense of hope that it will automatically go back to a previous price point. General Electric long considered a bellwether Blue-Chip Stock traded at $57 in 2000. Today the stock trades under $15/share.
- Overconfidence: the tendency to be overly optimistic about the quality of your information and/or your ability to act on it at the right time for maximum gain
This shows up everywhere in life: one study found that up to 80% of drivers believe they are safer than the average driver. Other studies of professionals, such as doctors, lawyers, and CEOs, found them to have unrealistically high estimations of their abilities. While confidence is a good thing, overconfidence can get you into trouble.
One way we see overconfidence inflicting negative outcomes on investors is through excessive trading. One study by Barber and Odean found that investors utilizing advisors traded less and achieved better results than investors trading more actively and speculatively online. In another of their studies, they found a negative correlation between trading activity and portfolio returns, with the 20% most active traders earning 7.1% less than the 20% least active traders. Upon further investigation, they found that investor confidence was a prime factor inspiring the active investors to trade so frequently.
So how do you avoid this bias and realize better returns? Trade less and invest more. Anymore, you’re trading against institutional investors with resources you don’t have and algorithmic robots that trade at frequencies you simply can’t match. One study on this topic found more frequent retail traders are “basically paying fees to lose money”. Pay attention to the long-term secular trends, buy companies with good fundamentals, take advantage of dividend-paying stocks, and you’ll build wealth and income over time.
- Familiarity: investing in that which is accustomed to us rather than what may be best for us.
Many of us are creatures of habit. We take the same route to work, we go to the same stores for the same things, we eat at the same restaurants, etc. Why? Because humans are comfortable with familiar things. Familiarity bias, in investing, is the preference of individuals to remain confined to what is familiar to them. This takes a lot of forms, from only investing in stocks from your home country, to over-investing in your employer’s stock, to choosing stocks whose products you frequently use and enjoy.
Why is this an issue? Well, for starters, it leads to chronic under-diversification. A report published by the Securities and Exchange Commission (SEC) found that, while an investor should hold approximately 300 securities to be properly diversified, the average investor holds four. A 2008 study found that portfolios above $25,000 held seven stocks on average, and portfolios above $100,000 held an average of 12 stocks. Of course, proper use of ETFs is another good way to achieve proper diversification.
Why is under-diversification a problem? The less diversification you have in your portfolio, the more susceptible you are to market volatility exerting undue influence on your savings. Investing in your home country leaves you open to swings that could be counterbalanced by investing in international markets. From 1991 to 2013, almost half of the time international stocks outperformed US stocks, sometimes by as much as 22%. Overinvesting in your own company can leave you doubly exposed: for one, you’re already “invested” in your company by virtue of working there and drawing a salary from it. If an economic downturn were to occur, you may lose compensation or be furloughed, and you’d see a decrease in your retirement assets as well, giving you a double dose of financial pain. Choosing only stocks whose products you’re familiar with opens you up to a similar problem. The S&P 500 is grouped into 11 sectors; it’s highly unlikely that you come into direct contact with each of these sectors on a regular basis.
One way to address familiarity bias is to alter your perspective. Say to yourself, “if I just won $1,000,000 in the lottery, would I only invest in what I already know?” The answer is probably not. Another way to address this is to talk through your investments. Having a sounding board, such as a financial advisor, to work through investment choices can be an excellent way to avoid getting caught in this financial trap.
- The Gambler’s Fallacy
Let’s say you’re sitting at the slot machine in Vegas. You’ve been playing for hours, and you haven’t heard any bells ring. You need to keep playing, right? Aren’t you due for a big payout?
Well… no. This is an example of the Gambler’s Fallacy, the belief that future probabilities are altered by past events. This is a product of “representativeness” and leads us to overly rely on rules of thumb, or “stereotypical thinking”.
How does this impact investing? Let’s say, instead of a slot machine, you’re watching the S&P. It has a week of big positive returns, so you place a short-sale trade (betting the market will fall). It’s due, right? What goes up must come down, trees don’t grow to the sky. Well, no. A run of good returns doesn’t necessarily foretell a bad return.
How does this affect investors? We’ve been in a bull market for over a decade now. A lot of investors are starting to get nervous, feeling like we’re due for a downturn. As such, they may prematurely bow out of the market before the signs and data say that they should.
How can you address the Gambler’s fallacy? Take a disciplined, data-driven approach to investing. Simply knowing about the fallacy can help you avoid falling for it. Learn to see each event as a new beginning rather than a continuation of what previously transpired. Ask your advisor about this for more information.
To put it simply, people are complicated. They can only process so much information, and they often bring emotion into logical decision. This can result in approaching investments too confidently, only investing in what they already know, or believing an event is “due” for a payday. The first step to beating these biases is understanding them. After that, talk to a financial advisor about how to make sure your assets are invested to help you achieve your financial independence and retirement goals.
Our team of HCM Advisors are here to help as an accountability partner designed to keep you in check when you want to act on these biases. We help keep your long-term goals front of mind when short-term performance takes over.