Eliminating bias is nearly impossible, as humans we’ve been conditioned throughout our lives to carry traits of prejudice and favoritism. Financial markets are a prime example of humans biases proliferated to both extremes. Often, as investors we face many behavioral biases that are conflicting with our values and money. This is the core of behavioral finance which intersects the study of economics and psychology. Experts in this field examine how people’s emotions affect their financial decision making.
In 2017, behavioral economist Richard Thaler won the Nobel Prize for his work on this topic. His findings found that people don’t always make rational decisions when it comes to money. In fact, we kind of do the opposite. This may not come as a surprise to anyone, though. We can all learn from our financial mistakes from time to time. However, most of us cannot afford to make mistakes with our retirement money, that’s why I’ve organized the four most common investing biases that often lead to fatal mistakes. Avoiding these pitfalls can secure your retirement, keep your financial plan on track and give you financial peace of mind. So how can we minimize our biases and stay on track? Simple, eliminate the following behavioral biases within your investment strategy:
1 | Hot-hand fallacy, the notion that because one has had a string of success, he or she is more likely to have continued success. For example, one study found that casino gamblers bet more after winning than after losing.1 In other words, they bet more after winning because they believed that their chance of winning again was greater than before. This also happens in financial markets as investors make decisions based only upon recent information compared to all of the available data which can often lead to thinking current trends are the best predictors of what will happen next. Researchers on behavioral finance found that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year. Although financial products often include the disclaimer that “past performance is not indicative of future results,” self-directed traders or amateurs still believe they can predict the future by studying the past.
2 | Regret aversion, investors make decisions in a way that allows them to avoid feeling emotional pain in the event of an adverse outcome. This bias motivates people based on two powerful emotions, fear and greed. The theory of regret aversion or anticipated regret proposes that when facing a decision, individuals might anticipate regret and thus incorporate in their choice their desire to eliminate or reduce this possibility. For example, an investor who fell victim to the dot-com bubble or 2008 financial crisis and sold their equity positions at the absolute worst time would feel anticipated regret if the were to think about re-investing in the stock market again, thus their bias has caused them to lose out on gains. Regret aversion means people avoid or delay taking decisions that might lead to them suffering a loss. The problem is that there are lots of financial decisions that could cause regret – yet it is not always financially sensible to do nothing.
3 | Confirmation bias, have you ever thought of an investing idea then googled it and come to find your only finding more reasons to believe yourself? That’s confirmation bias, we seek out information to confirm our existing opinions and ignore contrary information that refutes them. This psychological phenomenon occurs when investors filter out potentially useful facts that don’t coincide with their preconceived notions. Therefore, investors suffer as a result. We tend to gather confirming evidence when making investment decisions rather than evaluate all available information. A quality decision-making process requires an open mind because evidence tends to cut in multiple directions and understanding all perspectives reduces the chances of error. Thus, if we can eliminate confirmation bias we will have a higher probability of making the best investment decision for your intended objectives. “The stock investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.” ― Benjamin Graham, The Intelligent Investor
4 | Hindsight bias, this occurs when we look back on past events and convince ourselves it was more predictable than it really was. “I knew that would happen.” Who hasn’t said or heard that, probably many times? While the know-it-all reminds people of their forecasting prowess, hindsight bias can have detrimental effects on one’s finances or investment strategy. We tend to overestimate the accuracy of our past predictions which leads to a false sense of security. This trap can negatively impact our future decisions. Believing that one is able to predict future results more accurately can lead to overconfidence. Thus, one begins selecting investments based on 'hunches' or 'gut reasons' rather then critically evaluating the investment opportunity with data driven facts and fundamentals.These gut investors also buy into stories more than hard data and many would agree this is speculative investing that ends up messy. “I have no desire to suffer twice, in reality and then in retrospect.” ― Sophocles, Oedipus Rex
Have you experienced any of these biases within your investments? If so, then you need a circuit breaker to help prevent these behavioral biases from creeping into your financial plan. As a financial adviser, we act as that circuit breaker between the pitfalls of human emotion and your money. We have access to base rate information, aka full historical stock market data and continuously monitor leading economic indicators. Everyday investors do not usually have the access to such information or time, and instead base their judgments about risk and return on “singular information” which is more recent or easily obtained. This strategy is flawed. In addition, the average investor doesn’t have a professional system in place to handle market corrections or oncoming bear markets so together we can do much more. Schedule a free consultation to review your plan and investment strategy.
1Croson, Rachel, & Sundali, James. (2005). “The Gambler’s Fallacy and the Hot Hand: Empirical Data from Casinos” The Journal of Risk and Uncertainty, 30 (3), pp. 195-209.