You Were Born to Be a Bad Investor.
It’s true, we all were. Our brains are wired to work against us reaching our financial goals. However, if you recognize why that is, and how to overcome it, you can be a wildly successful investor. It doesn’t take advanced education, a high IQ, or being a Chartered Financial Analyst. All it takes is patience and a fundamental understanding of the common biases and tendencies of the human psyche. Once you understand them, you can minimize their impact.
People’s tendency to chase the “hot idea,” affectionately known as “the fear of missing out” (FOMO). The belief that past events or outcomes were predictable, even though they were not. The unconscious search for meaning or patterns in meaningless and random events are all examples of behavioral and cognitive biases that can sabotage our financial success over time.
Behavioral Finance, an off-shoot of Behavioral Economics, studies how our unconscious biases influence our investing behavior and can negate even the best financial planning.
Well-known researchers in this area include Amos Taversky and Nobel Prize winner Daniel Kahneman, who conducted some of the first research in this field and published “Thinking Fast and Slow,” as well as Economist/Author Richard Thaler, who wrote the books “Misbehaving” and “Nudge.” If you’d like to gain insight into how your brain is wired to work against you, I highly recommend reading at least one of these books, if not all of them.
From an evolutionary standpoint, humans are wired to run from danger, perceived or actual, and to “trust our gut.” When we were hunter-gatherers, the unknown sounds in the distance or the rustling of tall grass as we migrated from one location to another might have been the last thing we heard. Those lessons learned over millennia are still ingrained in us today.
Technology has advanced, and modern humans have evolved significantly from a physical and cognitive standpoint, but our base psychological instincts are still the same. Find patterns, stay with the group, and don’t take unnecessary risks.
Understanding how those instincts and biases can affect us is the key to working toward overcoming them and progressing toward your financial goals.
Let’s examine a few of the biases researchers have uncovered and discuss their impact on investors.
Bias #1Loss Aversion Bias
We tend to favor avoiding losses over acquiring equal gains, even if the probability of gain is greater than the risk of loss. Loss aversion finds its roots in Prospect Theory, which states that people feel the psychological impact of a loss twice as powerfully as a gain, even if the loss and gain are equal. It causes us to put too much weight on low and high-probability events and too little on medium-probability events, leading to less-than-optimal decision-making. Suboptimal decisions can lead to risk avoidance or investors being “too conservative” in their investment portfolios. This can lead to holding too much cash or being under-allocated to equities or other investments with greater return potential to the detriment of long-term returns.
It can also lead to “get even-itis,” where an investor wants to hold on to losing positions until they get back to even, regardless of the future return potential of the investment (this is also a result of “anchoring” to the original investment price). Investors who fall victim to loss aversion bias tend to hold losers too long and sell winners too quickly.
While there is nothing wrong with taking profits along the way, the adage “let your winners run, and cut your losses early” can be a good rule of thumb to follow. We never recommend timing the market or short-term trading for long-term investors, but there are times when it can be appropriate to sell a losing position quickly. However, there is a difference between a high-quality investment which is down due to market or economic conditions, and a bad investment. Research and professional advice can help you make the distinction.
Bias #2 Bandwagon Effect
Better known as “Fear of Missing Out”, or FOMO, the bandwagon effect describes the impact that a widely held opinion or broad trend can have on our decision-making process, causing an investor to participate in what may not be an appropriate investment just because “everyone else is doing it.” Great examples of the bandwagon effect are the Dot-Com bubble (“every internet company is the future!”), the housing bubble during the early 2000s (real estate only goes up!”), and the crypto craze and meme-stock frenzy of 2020 and 2021 (enough said).
Each of these speculative bubbles started small and gained steam as people saw their friends and neighbors “making easy money” in what seemed to be unstoppable trends. More and more people piled in, some with their life savings, thinking the ride would never end. Alas, as the excitement faded and reality set in, each of these bubbles popped, and the latecomers, along with the HODLERS (hold on for dear life), ended up losing most, if not all, of their gains and original principal.
To be successful, investors must be able to think independently and closely examine the merits of “what everyone else is doing.” By thinking independently of the crowd and seeking professional advice, investors can avoid the bandwagon effect and improve their odds of making well-thought-out decisions that align with their long-term goals and keep them on the path to reaching their goals.
Bias #3 Confirmation Bias
“What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.” -Warren Buffett
Confirmation bias is the tendency to look for or put additional weight on information that confirms our previously held opinions or beliefs and ignore that which is contradictory.
Confirmation bias can lead to overconfidence (another bias in itself) in decision-making or the inability to see flaws and inconsistencies in data related to an investment under consideration. This can lead to believing that the investment “is definitely a winner” despite a wealth of evidence to the contrary. It can also lead to underestimating the potential risks of an investment or thinking that “nothing can go wrong,” and be caught by surprise when the investment moves against our thesis.
While this is one of the most difficult biases to overcome, “doing your homework” and intentionally seeking out contradictory information can be helpful to minimize confirmation bias.
When doing research on the markets, economy, or a particular investment, I always seek out no less than 3 different opinions or analyst reports that are in direct contrast to my conclusion. This helps me to have a more well-rounded view of the topic, and in certain cases, has caused me to modify or completely change my thinking. It doesn’t guarantee that a conclusion will always be correct, but it can make a difference in your success over time.
There are more than 50 emotional and psychological biases and fallacies that researchers have found and described relating to Behavioral Finance; we have only examined three of the more common of those, barely scratching the surface. Understanding these three is a good starting point, but learning more about how the remaining biases affect decision-making and learning more about yourself as an investor will undoubtedly have a positive impact on your success as an investor.
At Gulfside Wealth, we incorporate Behavioral Finance into our portfolio construction, our client conversations, and our financial planning. Our goal is always to help our clients overcome what may be ideas, thoughts, or actions that would be detrimental to their long-term financial success.
We are committed to being responsible stewards of our clients’ hard-earned wealth, and working with them to make progress toward their financial goals.
If you’d like to learn more about Behavioral Finance, how some of the more common biases may impact you, or have one of our Advisors review your investment portfolio or financial plan, please contact our office.