One of my greatest interests is Behavioral Finance, the study of how cognitive and emotional biases affect investor behavior. Left unchecked, these behaviors can (and often do) lead to worse outcomes for an investor’s portfolio.
No one is immune to cognitive and emotional biases (including me), but a knowledge of them can help us prime ourselves to catch a cognitive bias in action before it has a chance to negatively affect your investment strategy.
What is a Cognitive Bias?
A cognitive bias is a systematic pattern of deviation from rationality in judgment. They occur because humans experience reality subjectively—our own experiences color our perceptions of how the world functions, whether they represent the truth or not.
Here are some common cognitive biases with examples of how they can undermine investor behavior.
1. Hindsight Bias: “I Knew it All Along”
Because we can see how events unfolded after the fact, it often seems obvious—or even inevitable—that they would always turn out that way. In the study of history, this is referred to as “retrospective determinism.”
The danger lies in someone having been “proven right” and using their predictive powers for portfolio decisions moving forward. Obviously, there are a multitude of ways that events could have unfolded throughout history based on slight alterations.
Mitigating Hindsight Bias: When major market events occur, take time to consider how things could have happened differently, based on different variables. Remember how many of those variables might have been unknowable and don’t rely too closely on hunches to make investment decisions. Above all, remember: “past performance is no indicator of future results.”
2. Confirmation Bias: “This Article Backs Me Up”
Confirmation bias is closely related to hindsight bias. Humans instinctively lend more weight or credence to outside materials (articles, news reports, forum threads) that back up already-held beliefs. People are more likely to seek out material from sources that they agree with and are more likely to dismiss sources that present challenges to their views.
This is understandable. All of us wants to be reassured that we are on the right path and are making the right decisions, but only surrounding yourself with views that reinforce your own creates a cultivated echo chamber divorced from whatever economic and market realities might be at play.
Mitigating Confirmation Bias:
Cultivate a group of sources that express a wide variety of views but remember that an opinion is not the same thing as a fact. There’s an old joke in journalism: “if one source says it’s raining and another says it isn’t, your job isn’t to report what both said. It’s to go outside and look up.” For our part here at Opus, we constantly engage with researchers from a variety of institutions (both those we invest with and those we do not) to attempt to consider the full perspective of the market before building a diversified portfolio designed to help you reach your goals.
3. Recency Bias: “Markets Only Go Up…Right?”
If you’ve been in the stock market in the past decade, you’ve had a pretty great experience. Even factoring the brief jolt from COVID-19 and the pullback in 2022, the S&P 500 is around 5,600 at the time of writing, compared to about 2,100 roughly 10 years ago. Anyone who only started seriously investing in the past decade might be deceived into thinking that this is a normal stretch of market performance.
Such an investor would be exhibiting recency bias, a cognitive predisposition that causes people to prominently recall recent events. The most devastating effect of recency bias in an investment portfolio is an attraction to recent short-term performance from specific investment classes or managers, thinking that “what has been shall continue to be.” This has the knock-on effect of often buying something at the peak of its value in a market cycle, right before things take a plunge.
Mitigating Recency Bias: Remember that both markets and economies (not the same thing, by the way) are both cyclical. Market pullbacks and recessions are a normal part of this cycle and occur with surprising regularity. Rather than trying to chase the hot dot and time the market, a disciplined approach to maintaining a diversified portfolio and adding money to that portfolio (through things like a Periodic Investment Plan or the salary deferrals into your 401(k) at work) are great ways toward staying focused on your long-term goals and tuning out short-term noise.
4. Mental Accounting: “My Bonus is My Play Money”
First coined by one of the fathers of modern behavioral finance Dr. Richard Thaler, mental accounting is a person’s tendency to evaluate outcomes by grouping their assets into a number of “mental accounts.” For instance, someone might group their assets by how they are acquired (work, inheritance, a bonus, finding money in the street) or by the nature of the money’s intended use (necessities, leisure, gifts).
Mental accounting is a mixed bag. The automatic contributions mentioned above to retirement plan and nonqualified investment accounts are forms of mental accounting. Both are systematic uses of money that you have earmarked for a specific purpose: supporting you after you stop working, or growing for a future expense.
The downside of mental accounting comes if people begin to fixate on their “buckets,” neglecting correlations and similarities across their entire portfolio. It can also lead investors to overvalue the role of investment income or capital appreciation in their portfolio to the detriment of the other holdings (“why do I need to own these bonds, look at what my stock returns have produced!”).
Mitigating Mental Accounting: Not all forms of mental accounting are a bad thing. Still,it is important to remember that a dollar is a dollar at the end of the day. The goal of portfolio construction is to allocate each dollar to its specific purpose to help you achieve your short and long-term goals. That might involve keeping some of those dollars in cash to deal with expenses, while allocating others for aggressive growth. It is critical to keep your eye on the big picture of your total financial landscape, both for the present and the future.
5. Familiarity Bias: “I Only Invest in What I Know”
People seek the familiar. They feel they have a better understanding of things that are well-known to them. This bias manifests itself in a number of ways—from people overinvesting within their own industry (a mechanic overinvesting in auto manufacturers, for example), to investing in companies that are based in their hometown or region.
A major facet of familiarity bias is “home country bias,” a tendency for investors to over-allocate their portfolios to domestic holdings. Consider that the American stock market represents approximately 60% of the world’s stock market capitalization, but only about 25% of its Gross Domestic Product (GDP). Shouldn’t a truly globally diversified portfolio have somewhere between 40 and 75 percent of its equity holdings in international stock? Instead, the average American investor has close to 90 percent of their holdings in domestic companies. While this is an oversimplification, it is representative of the fact that people seek comfort in stock holdings that are familiar to them.
Mitigating Familiarity Bias: The main way to combat familiarity bias is to keep a close eye on not over-allocating yourself to things that are familiar just because you are aware of them. Ways to avoid this include utilizing high-conviction active managers, index-based solutions for a portion of your assets to gain broader exposure to the market, and earmarking a greater portion of your assets for international allocations than might typically be considered normal. We utilize all three techniques in our approach to portfolio construction.
What is an Emotional Bias?
An emotional bias is a distortion in cognition and decision making due to emotional factors. You may recall MacLean’s Triune Brain hypothesis, which postulated that human brains had a reptilian base which governed reflexes and survival instincts, a paleomammalian complex (the limbic system) which governed emotions, and the neocortex which governed speech, logic, and higher thinking. The model has been disproven from a neuroscientific perspective, but the Triune model is often still used in discussions of Behavioral Finance because it strikes to the reality that emotional reactions are often felt more viscerally and have greater hold over us than cognition.
The end result? Emotional biases are tougher to shake than cognitive biases, because they tend to take a deeper hold over us. Here are some common emotional biases that occur in the world of investing:
1. Loss Aversion: “I Hate to Lose”
Not-so-fun-fact: human beings experience the pain of a loss twice as profoundly as they experience the pleasure of a commensurate gain. Daniel Kahneman and Amos Tversky coined the term “loss aversion” in 1979 to describe this phenomenon.
An aversion to loss can lead to investors holding items in their portfolio that have performed negatively, even when that holding’s prospects look grim. This is often compounded in nonqualified accounts, where the capital gain or loss on an asset is not realized until it is sold. Some investors continue to hold something well past when they should, since refusing to sell it is akin to refusing to recognize that the investment has failed to play its role in their portfolio.
Loss aversion’s other big role in hamstringing portfolios is causing investors to sell successful investments too early in order to “lock in” their modest gains out of fear of a future possible downturn. Combined between the two, the loss-averse investor will hold their unsuccessful holdings too long and their successful ones too briefly to achieve long-term success.
Mitigating Loss Aversion: Creating hard rules for exit points for investments (both on the upside and downside) is one way for an investor to mitigate loss aversion—but only if they stick to those rules when the time comes. Systematic rebalancing of a portfolio at regular intervals can also combat loss aversion. Above all, the investor must be able to critically evaluate their own feelings about a holding, and whether that holding still makes sense for their portfolio.
2. Regret Aversion: “What If I Do the Wrong Thing?”
The “yin” to loss aversions “yang,” regret aversion keeps investors from taking decisive action because they are worried that it may prove to be a suboptimal decision. It keeps people on the sidelines from getting into the market because they are concerned about a potential immediate decline.
The potential angst isn’t just in dealing with a concrete financial loss, but in the realization of having made the wrong decision. Opus’ founder, Jim Harvey, has cut out the middleman with what he jokingly refers to as his “Theory of Remorse Management.”
IF YOU:
Buy an asset and it declines/stays flat – “Why on Earth did I buy that?”
Buy an asset and it goes up – “Why didn’t I buy more?”
Sell a declining asset and it declines – “Why didn’t I sell sooner?”
Sell a declining asset and it rebounds – “Why did I sell?”
Sell an appreciating asset and it keeps appreciating – “Why did I sell so early?”
In fact, the only outcome that won’t have a potential knife to twist is if you sell an appreciating asset that then begins to decline. So all you must do is perfectly time the market with every investment decision you ever make and you won’t have to worry about it!
Mitigating Regret Aversion: To err is human. Every investor at some point will make an investment decision that they wish they could take back. Regret aversion tends to only demolish portfolios if an investor affected by it holds out against selling for too long (see Loss Aversion above) or allowing past regrets to make them too hesitant to engage with the investment world in the future. Remember that the investment timeframe for disciplined investors is measured in decades, not months or days. In the long-term, an investor’s chances of experiencing gains with a consistent, well-diversified approach are quite high.
3. Self-Control Bias: “But I Really Want That Now”
I often joke that spending money is like pouring liquid into a container – the liquid will assume whatever shape you pour it into. Self-control bias, simply put, is the innate human desire to spend more lavishly now with money you have on hand, rather than invest it for the future.
Mitigating Self-Control Bias: With SYFI, we strive to strike a balance between the wants of the now and the wants of the future. I don’t see the need for self-imposed asceticism for the sake of the future, but we do need to put guardrails in place to make sure enough money is being allocated to growth for future needs.
As with many cognitive and emotional biases, discipline and automation are amazing weapons here. Both automated retirement savings (like your 401(k) and Periodic Investment Plans (PIPs) automatically move money into your investment accounts. In a 401(k), the money is taken out of your paycheck before it even hits your bank account—it’s tough to spend what you never receive! PIPs help the same way, especially with nonqualified accounts. They can move money from low-yielding savings accounts into fixed income strategies, or to growth allocations for future needs. I have one client who has set up their PIP to pull money from their bank account the day after they receive their paycheck. Remember that humans have always struggled with impulse control, but many studies have shown that investors who make a plan and stick to it regarding their long-term financial goals experience orders of magnitude more success in achieving those goals than those without a plan.
4. Endowment Bias: “I Own It, So It Must Be Worth More”
Generally speaking, investors value what they already own more than what they do not. As a result, investors are resistant to change once they take ownership of an asset.
This is often seen in inheritances, where once an investor takes possession of a portion of a loved one’s estate, they are resistant to selling it (despite having received a stepped-up cost basis, minimizing their own capital gain). At times, people will even form a sentimental attachment to shares of a company that they have inherited, even if that company makes no sense as part of their larger overall portfolio.
Mitigating Endowment Bias: Consider if you had an equivalent amount of cash to whatever the asset in question is currently worth. Would you use all the money to purchase the same amount of said asset? Reframing your thinking about the assets in your portfolio (and the role they play as part of a larger whole) is crucial to making informed decisions about when to part ways with an asset.
Closing Thoughts
Emotional and cognitive biases will always be a part of investing. Anything involving risk will usually have a chance of drumming up strong emotions. Successful investors, however, are able to work through these emotions without letting themselves (or their portfolios) be governed by them. Having a working knowledge of these biases ahead of time can help you identify them when they rear their heads. Hopefully, through close work with a trusted team, you can pry yourself free and keep you and your portfolio on the path to allow you to live the life you’ve imagined.