Published On: June 10, 2020
Written by: Ben Atwater and Matt Malick
Over the coming weeks, we will take a deep dive into behavioral finance. This is a fascinating area and one that is incredibly important, not only to our investment decisions, but in our everyday financial decision-making and our long-term financial planning.
Given the market action in 2020, we cannot think of a more relevant time to look at this crucial subject.
Behavioral finance is the crossroads of psychology and economics. It recognizes that investors are not always rational, have limits to their self-control and have biases that influence their decision-making.
That all sounds obvious, but amazingly, for decades, economists ignored all of this. As more and more academic economists and finance professors tried to quantify the “science,” they needed to make certain assumptions. These included the idea that markets and investors were perfectly rational, utilitarian, and that the investor mind was free of cognitive errors.
A purely quantitative (equation-based) approach to finance and economics does not work unless academics assume markets are completely efficient and people are totally rational. Thinking back to our college years, no one questioned these sacrosanct ideas, and this was the prevailing curriculum.
Increasingly, it seems a naive school of thought. With each passing year, the idea grows that human psychology drives economic decision-making and therefore economics.
Today, we are going to look at four classifications of decision-making biases – self-deception, heuristic simplification, emotional bias, and social influence. It is important to remember that these four areas tend to overlap and intertwine.
The first is self-deception. This boils down to our human tendency to think we know more than we do. Self-deception is denying or rationalizing away the relevance, significance, or importance of opposing evidence.
This can happen easily today as the result of political ideology in a country where people are so divided. Political leanings can also influence savings, spending and investment decisions regardless of the broader context. It is never smart to invest based on your political preferences or your personal economic forecasts.
Another decision-making bias is called heuristic simplification. This involves cognitive shortcuts or rules of thumb we use to simplify decision-making under conditions of uncertainty. Heuristic simplification often involves our substituting an easy question for a difficult one.
Heuristics are sometimes necessary. For example, as investors we look at certain criteria like free cash flow and dividends to make stock selection decisions. This will very often keep us from buying a company that burns through cash while speculators bid up the stock price to spectacular heights. But it should also help keep us from making a debilitating error of owning an unprofitable company based solely on a rising stock price.
Heuristics are not necessarily bad if we are cognizant of how it might impact our decision-making.
Next are emotional biases, which can occur based on your personal feelings at the time a decision is made or may be deeply rooted in personal experiences influencing your decision-making.
Emotional biases are usually ingrained in the psychology of investors and can generally be harder to overcome than cognitive biases. But like heuristics, emotional biases are not always errors.
Say you are a doctor with real knowledge and genuine excitement about a certain therapeutic. This overconfidence might lead you to purchase the stock of the company that developed and markets the therapeutic, but your emotional connection to this drug does not mean its manufacturer is a good investment.
Lastly is social influence, which is also known as herd mentality. And it is EXTREMELY prevalent in our current environment. There is a repeated phenomenon in markets resulting in massive selloffs and equally powerful rallies. In many cases (if not all) these swings are two parts sentiment and one part “fundamentals.”
Whether it was the 1987 stock market crash, the tech-bubble in the late 1990s, the subprime crisis in 2008, the Eurozone crisis in 2011 or the present COVID-19 crisis, the buying and / or selling tends to be overdone in one direction and then the other. This is because buying begets more buying and selling begets more selling.
To this day, there is still no generally accepted reason for the 1987 stock market crash where the market fell by 22.6% in one day. Largely the explanations vary around the idea that everyone simply freaked out on the same day. A true herd mentality took hold.
The four classifications of decision-making biases (self-deception, heuristic simplification, emotional bias, and social influence) can occur independently or simultaneously. To additionally complicate things, these biases are not always bad. They can be helpful. The key though is recognizing them. Thinking about why we make our investment and financial decisions is key to determining if the decision is prudent.