You Might Have a Behavioral Bias if...
Jeff Foxworthy, a stand-up comedian with a southern twist, built up his popularity with an original bit he calls, “You Might be a Redneck if…” In these routines, he tests the audience with points to ponder such as, “You might be a redneck if your lifetime goal is to own a firework stand,” or “You might be a redneck if your salad bowl set says Cool Whip on the side.”
We Aren’t Always Rational
We will let you make your own decision about redneck behavior and Mr. Foxworthy’s humor (there is an abundance on YouTube), but one set of behaviors we do want to caution you about are behavioral biases that impact investing. You may have seen articles covering this topic throughout the years. While we’d often like to think we’re completely rational people, studies repeatedly show that we are imperfect. We have emotions and brains that don’t always act in a rational pattern. Biases are deeply rooted in our psyche and affect our investing. In fact, Dr. Richard Thaler and Dr. Daniel Kahneman were each awarded a Nobel Prize for research on the interaction of our brains and money. If you are unfamiliar with this subject, it’s something worth educating yourself about as biases can affect your bottom line. Great reads on this subject include Thinking, Fast and Slow (Kahneman) and Nudge (Thaler), or Your Money & Your Brain by Jason Zweig. These will dive deeply into the world of behavioral biases.
As a primer, let’s quickly play, “You Might Have a Behavioral Bias if…” to learn about a few investing biases that may prevent investors from being objective and honest about their investments. Try your best to imagine Jeff Foxworthy reading these.
Overconfidence Bias
This is undue faith in one’s reasoning, judgment, and cognitive abilities. If you spend all of your time trading stocks and believe that you have special knowledge that others don’t possess, then you might have a behavioral bias. If you believe you can perfectly evaluate a company as an investment, then you might have a behavioral bias. If you think you can find the “next hot stock,” then you might have a behavioral bias.
Self-Attribution Bias
The tendency for individuals to ascribe successes to talent or foresight and blame failures on the part of bad luck. If you make excuses when your investments don’t pan out (e.g. no one could have foreseen this event) yet claim special insight or skills when they do, then you might have a behavioral bias. If you believe the market was impacted by your action (or inaction), then you might have a behavioral bias.
Mental Accounting
The tendency for people to categorize their assets into several non-interchangeable mental accounts (Pompian). If you prefer to earn interest or dividends over capturing total returns, then you might have a behavioral bias. (See our Dangerous Devotions to Dividends blog.) If you focus on one holding in your portfolio and fail to look at the whole portfolio, then you might have a behavioral bias.
Loss Aversion Bias
People generally feel a stronger impulse to avoid losses than to acquire gains (Pompian). If you are holding onto a losing investment, waiting for it to recover, then you might have a behavioral bias. If you sell winners to “capture the gain,” then you might have a behavioral bias. If you haven’t rebalanced your portfolio in a long time, then you might have a behavioral bias.
Home Bias
The tendency for people to be drawn to investments that they “know.” If your equities are composed primarily of U.S. companies, then you might have a behavioral bias. If you heavily weigh your portfolio to the industry you work in, then you might have a behavioral bias. If you think your company stock is less risky than others, then you might have a behavioral bias.
Having Biases is Normal - But They Can Harm Your Portfolio When Ignored
These 5 biases just scratch the surface of how our brain handles money. There are many other behavioral biases that have been found in the world of finance. So, even if none of these apply to you, there is still a decent chance you aren’t out of the woods yet. On the other hand, if all of them applied to you, we want you to know you are normal. Because of our emotions and biases, it is very hard to remain completely objective and rational. However, if we allow biases into our investing, we generally find an improper allocation of risks and inappropriate assessments of skill and performance. Not addressing these biases can be detrimental to investment returns.
If you have an adviser, you should talk to them about how biases may be impacting your investment strategy and what processes to put in place to counterbalance those instincts. A word of caution though, many advisers suffer from and propagate these same biases. Has your adviser recommended individual stocks or asserted that he/she has foresight into the market? If you don’t have an adviser, one way to guard yourself against behavioral biases is to seek out investment approaches that are systematic or find an adviser well-versed in this topic.
