Published On: August 7, 2020
Written by: Ben Atwater and Matt Malick
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. It 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. The essays below discuss behavioral finance and how it can help or hurt your finances.
Published: August 27, 2020
Loss aversion is people’s general preference for avoiding losses over acquiring gains. Academic experiments indicate people are twice as sensitive to losses. The classic experiment in this area is to introduce the scenario below and have subjects choose their preference.
Most people choose number two. However, from a probability standpoint, the expected return of number one is $250 while the expected return of number two is only $125. Nonetheless, we are inclined to worry more about loss than gain, so we tend to choose the “sure thing.” This has all kinds of investment implications.
Published: August 17, 2020
Framing bias occurs when we decide based on how someone presents information to us, as opposed to simply on the facts themselves. Someone presenting the same facts in two different ways can lead us to make different judgments. Let us consider someone who invested $1,000,000 five years ago and their portfolio has grown to $2,000,000. We will now assume the market has a meaningful correction and falls by 20%. This investor now has a balance of $1,600,000. Following this downturn, the investor is far more likely to lament the $400,000 that they recently lost than to appreciate the $600,000 that they earned on their original investment. This is a case of framing. Framing tends to have a negative bias because study after study has shown investors find losses more troubling than they find gains satisfying.
Published: August 7, 2020
Representativeness is a form of heuristic bias occurring when we make the mistake of believing two similar things are more closely correlated than they are. Simply because an event is representative does not mean its occurrence is more probable. The proverbial coinflip exercise is an excellent illustration of this. Say you observe someone flipping a coin and four times in a row it comes up heads. The coin flipper asks you to wager on the fifth flip – heads or tails. Most of us would choose tails because it seems a low probability that the flipper would flip heads five times in a row. This is the prototype. However, the fifth flip’s probability of heads is still 50% and of tails is still 50%. The prior flips, no matter their result, do not impact the probability of the next flip. This is our base rate.
Published on: July 27, 2020
Narrative fallacy acknowledges our tendency to weave a story to explain concepts so we can more easily understand or remember them. Our biology hardwires us to love stories and we let our preference for a good story impede our critical thinking. The better the story, the more it draws us in. Stories have emotional content which appeals to our subconscious and stories are easier to remember and conceptualize versus facts and figures. Whether it be a particular investment or an investment strategy, people tend to be programmed around stories (or dreams) of big wins. The reality is that with big wins comes big risk. People tend to ignore the risk part of this equation. Ironically, it is not big wins that build wealth for the vast majority, but rather avoiding unforced errors. Most investors are better off in a lower risk and lower return strategy than the opposite.
Published on: July 21, 2020
Herding mentality, or simply herding, occurs when we make decisions based on a perception of what other investors are doing rather than any underlying security analysis. Herding is extremely prevalent in our current environment. The combination of ultra-low interest rates, a COVID-damaged economy and unsightly fundamentals is causing investors to buy stories about the future rather than buying fundamentals.
Published on: July 7, 2020
“Confirmed” discusses confirmation bias in regard to investing. Confirmation bias is our tendency to pay close attention to information that confirms our beliefs and pay less attention to information that contradicts it. With investing, we tend to see two different types of people, those who think the stock market is headed higher (bulls) and those who think it is heading lower (bears). In many cases, we see people who are always bullish (permabull) or always bearish (permabear). These folks tend to be the most famous because their followers can always point to their forecasting successes. After all, a stopped clock is right twice a day.
Published on: June 30, 2020
Hindsight bias is a misconception arising after an occurrence in which we convince ourselves we always knew the occurrence would take place and we always knew what the ramifications would be. In many cases, we may even go so far as to say we predicted the occurrence and its aftermath. Academics have repeatedly proven this phenomenon. For example, before an election they will survey a group and ask them to predict the winner. After the election, the academics will then ask the same group how many of them predicted the winner. A much larger percentage always say they predicted the winner after the election than the percentage of those who predicted the winner before an election.
Published on: June 23, 2020
In our retirement planning work, one of the most important factors to understand is the level of spending required to support your standard of living. When we dig into spending with clients, we have observed a human tendency to significantly underestimate household spending. In other words, people can believe they are quite frugal, while at the same time spending meaningful sums. Take our current predicament of social distancing as an example. Because of our new reality, recreational vehicle manufacturers are reporting a spike in sales as consumers see RV’s as necessary to adapt to the new normal. We are seeing a similar surge in demand for swimming pools, bicycles, home renovations and outdoor furniture.
Published on: June 16, 2020
We can best explain overconfidence using a George Carlin joke. Carlin said that anyone driving faster than you on the highway is a “maniac” and anyone driving slower than you is an “idiot”. We all tend to think we are above average, whether driving or investing. The overconfidence can lead to taking on too much risk.
Published on: June 10, 2020
With each passing year, the idea grows that human psychology drives economic decision-making and therefore economics. “Behave” discusses four classifications of decision-making biases – self-deception, heuristic simplification, emotional bias, and social influence – and encourages thinking about why we make our investment and financial decisions.