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, and over the course of several months, we will. But to get us started, we have decided to focus on three; Endowment Bias, Loss Aversion Bias, and Anchoring Bias. 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.
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. This is what we are here for. To help keep your long-term goals front of mind, when short-term performance takes over.
Interested in learning more about the various Cognitive Biases that can impact your financial behavior? Stay tuned. HCM’s Doug Johnson and Casey Boland are working on a presentation for the spring of 2019. In the meantime, don’t hesitate to reach out with any questions you may have. And look forward to additional biases in coming blog posts.