Investors Are Their Own Worst Enemies

Why we succumb again and again to our worst behavioral biases

By Robert Pyle


Key Takeaways

·         There are four common behavioral biases that tend to derail investors.

·         Unsettling times can bring these biases to the surface, even among normally level-headed investors and savers.

·         Learning how to detect the signs of hindsight, loss aversion, pattern recognition and recency bias can save you tremendous sums over the long term—and improve your sleep

Study after study shows that investors are often their own worst enemies. Why? Because we have emotions and we have biases, some we many not even recognize.

As investors, we tend to leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done. The past few weeks of wrenching market volatility, global economic drama and screaming headlines has caused even the most level-headed of investors to start questioning their investment strategy.

 

Don’t!

Why do we have behavioral biases?

Most of the behavioral biases that influence our investment decisions come from myriad mental shortcuts we depend on to think more efficiently and to act more effectively in our busy lives.

Usually these mental short-cuts work well for us. They can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we’re simply trying to stay afloat amid the crush of deliberations and decisions we face every day. But, these biases are not always reliable

What do they do to us?

The same survival-driven instincts that are so helpful in our daily lives can become deadly when investing. They overlap with one another, gang up on us, confuse us and contribute to multiple levels of damage done.

Even after you’ve learned to recognize your biases, they’re hard to combat. They’re your brain’s natural instincts that kick in long before your higher functions kick in. Behavioral biases trick us into wallowing in what financial author and neurologist William J. Bernstein, MD, Ph.D., describes as a “petrie dish of financially pathologic behavior,” including:

 

1.      Counterproductive trading – incurring more trading expenses than are necessary, buying when prices are high and selling when they’re low.
 

2.      Excessive risk-taking – rejecting the “risk insurance” that global diversification provides, instead over-concentrating in recent winners and abandoning recent losers.
 

3.      Favoring emotions over evidence – disregarding decades of evidence-based advice on investment best practices.

 

What can we do about them?

First, become familiar with the most common behavioral biases, so you can easily recognize them and prevent them from derailing your investment decisions.

Anchor your investing in a solid plan.  

By anchoring your trading activities in a carefully constructed plan (with predetermined asset allocations that reflect your personal goals and risk tolerances), you’ll stand a much better chance of overcoming the bias-driven distractions that rock your resolve along the way.

An alphabetic overview of behavioral biases

 

Let’s review some of the biases that come into play after a volatile year in the financial markets. We may all question the value of diversification when the U.S. financial markets outperform the international markets as they did this year (as of mid-December 2018), but there can be long periods when international stocks outperform. For more, see Why Should You Diversify.

The main behavioral biases that come into play after a volatile year are:

1.      Hindsight Bias,

2.      Loss Aversion,

3.      Pattern Recognition, and

4.      Recency Bias.


It’s tempting to think we should not have had international stocks in our portfolios this year (recency and hindsight biases), even though in 2017 international stocks easily outperformed U.S. stocks and other asset classes. We tend to rely on our pattern recognition instincts to predict the current trend into the future. It’s like using yesterday’s weather to predict what the weather will be like every day going forward into the future. Then, we start telling ourselves we don’t want to buy international stocks because we are afraid they’ll go down (loss aversion).

If you read the summaries below, see if you are feeling some of these biases this year.

1. Hindsight

 

What is it? In his iconic book “Thinking, Fast and Slow,” author Daniel Kahneman describes hindsight bias as a “robust cognitive illusion” that causes us to believe our memory is correct when it is not—it’s the old “I knew it all along” illusion. For example, say you expected an election candidate to lose, but she ended up winning. When asked afterward how strongly you predicted the actual outcome, you’re likely to recall giving it higher odds than you originally did.

 

When is it harmful? Hindsight bias can be very dangerous for investors, since your best financial decisions come from realistic assessments of market risks and rewards. As Kahneman explains, hindsight bias leads observers to “assess the quality of a decision not by whether the process was sound, but by whether its outcome was good or bad.” If a high-risk investment happens to outperform, but you conveniently forget how risky that investment truly was, you may load up on too much of it and not be so lucky moving forward. On the flip side, you may too quickly abandon an underperforming holding, deceiving yourself into dismissing it as a bad bet to begin with.

 

2. Loss aversion

 

What is it? “Loss aversion” describes the phenomenon in which most people feel the pain of losing more strongly than they feel the joy of winning. This greatly alters the way we balance risk and reward. For example, in “Stumbling on Happiness,” Daniel Gilbert argues that most of us would refuse a bet that gives us an 85 percent chance of doubling our life savings if it contained a 15 percent chance of losing everything we own. Even though the bet offers very favorable odds of a big win, the fact that there remains a slight chance that we could go broke leads most people to decide the bet is not worth the risk.

 

When is it harmful? One way loss aversion works against you is when you decide to sit in cash or bonds during bear markets – or even during bull markets when you feel a correction is imminent. Study after study shows that sitting out the markets, even during a downturn, will cause you to have a lot less money over the long-term than if you had just stayed fully invested. And yet, the potential for future loss can frighten many of us into abandoning our carefully planned course toward the likelihood of long-term returns.

 

3. Pattern recognition

 

What is it? Is that a zebra, a cheetah or a light breeze moving through the grass? Since prehistoric times, when our ancestors depended on getting the right answer, right away, evolution has conditioned our brains to find and interpret patterns. Back then it was a survival skill and that’s why, our pattern-seeking impulses tend to treat even random events (like 10 coin flips, all heads) as if they’re orderly outcomes suggesting a predictive pattern. “Just as nature abhors a vacuum, people hate randomness,” wrote financial blogger Jason Zweig, as a result of our brain’s dopamine-induced “prediction addiction.”

 

When is it harmful? Speaking of seeing red, Zweig published this fascinating piece showing how something as simple as presenting financial numbers in red can make investors more fearful and risk-averse than if they saw the same numbers in black. That’s a powerful illustration of how pattern recognition can influence us – even when the so-called pattern (red = danger) is a red herring.


Is any given stream of breaking financial news a predictive pattern worth pursuing? Or is it simply a deceptive mirage? Given how hard it is to tell the difference (until hindsight reveals the truth), investors are best off ignoring the market’s many glittering distractions and focusing instead on their long-term goals.   

 

4. Recency

 

What is it? Recency causes you to pay more attention to your most recent experiences, and to downplay the significance of long-term conditions. For example, in their book “Nudge,” Nobel laureate Richard Thaler and Cass Sunstein observe: “If floods have not occurred in the immediate past, people who live on floodplains are far less likely to purchase insurance.” That’s recency, tricking people into ascribing more importance to the lack of recent flooding than to the bigger context of being located on a flood plain.

 

When is it harmful? Of course buying high and selling low is exactly the opposite of investors’ actual aspirations. And yet, no matter how many times our capital markets have moved through their bear-and-bull cycles, recency causes droves of investors to stumble every time. By reacting to the most recent market jolts instead of staying true to their plan for long-term growth, investors end up piling into high-priced hot stocks and locking in losses by selling low during the downturns. They allow recency to get the better of them … and their most rational, evidence-based investment decisions.

 

A Behavioral Bias Overview

The Bias

Its Symptoms

The Damage Done

1. Hindsight

“I knew it all along” (even if you didn’t). When your hindsight isn’t 20/20, your brain may subtly shift it until it is.

If you trust your “gut” instead of a disciplined investment strategy, you may be hitching your financial future to a skewed view of the past.

2. Loss aversion

No pain is even better than a gain. We humans are hardwired to abhor losing even more than we crave winning.

Loss aversion causes investors to try to dodge bear markets, despite overwhelming evidence that market timing is more likely to increase costs and decrease expected returns.

3. Pattern recognition

Looks can deceive. Our survival instincts strongly bias us toward finding predictive patterns, even in a random series.

By being predisposed to mistake random market runs as reliable patterns, investors are often left chasing expensive mirages.

4. Recency

Out of sight, out of mind. We tend to let recent events most heavily influence us, even for our long-range planning.

If you chase or flee the market’s most recent returns, you’ll end up piling into high-priced hot holdings and selling low during the downturns.

Conclusion

As human beings, we’re wired to flee from danger, make snap judgements, seek recurring patterns and use the past to try to predict the future. It’s not easy putting emotions aside during times of stress. But, those who can stick to their plan and remain rational in the face of uncertainty tend to fare well in both their financial lives and their personal lives.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

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