Published On: September 19, 2018
Written by: Ben Atwater and Matt Malick
“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
In late July, we wrote an overview on the topic of behavioral finance. We received a positive response from readers and we decided to further elaborate on the subject. In this essay, we will examine some of the common investor biases that researchers have discovered.
Behavioral finance is about how our psychology and emotions impact our investment decisions. How we react to information overload, stick to our discipline, avoid a herd mentality, nullify temptation, etc. all test our fortitude.
The greatest difficulty with investing is that it’s counterintuitive to human nature. People should be lowering risk during boom times (when prices are high) and increasing risk during times of distress (when prices are low), but human nature totally contradicts this. For example, we are hardwired to run away from a fire, not to run into a fire.
Below we define some of the most commonly observed investor biases. These are things we don’t even know are happening, traits that exist in the automatic part of our brains and outside of our conscious awareness, and that often feel right, but are usually very wrong:
Recency Bias: Taking what is happening today and assuming it will simply continue in the future. This is the bias we see most frequently.
Overconfidence Bias: This tends to occur during longer periods of strong market performance. Usually, as markets go higher and higher, leadership narrows, meaning a small handful of large stocks do well, sending indexes to ever higher levels, which makes investing seem easy. People “know” that buying a handful of leading stocks will result in high returns with little risk because these companies have “strong fundamentals.”
Confirmation Bias: This occurs when investors seek out new evidence that confirms preexisting beliefs. In times of extreme optimism or pessimism, this bias becomes common as consensus market views drive the news cycle. It was incredibly easy to find “depression” stories in 2009 and it’s just as easy to find “record high” stories in 2018. On a more micro level, looking at individual investment ideas like Amazon, Netflix, gold or cryptocurrency, you can surely find highly detailed articles on the internet to support your position, bullish or bearish, on any imaginable trade.
Present Bias: Putting too much emphasis on now and not properly considering the future is present bias. Most commonly in financial planning, this is an issue of under-saving. Specific to investing though, this usually takes the form of assuming too much risk. Everyone wants an investment that will soar in value, which by definition means you are also assuming very high risk. It’s easy to forget that going for a big gain now may result in a large loss, which could meaningfully impair your long-term financial goals.
Choice Paralysis: Over the years we’ve seen many people debating when to get into the market. That’s a mistake. Even if the market is historically overvalued, it can still run much higher. When the market is down, you’ll never buy exactly at the bottom. Instead, regardless of a high or low market, establish a beachhead with a long-term allocation leaving flexibility to marginally add or subtract risk.
Disposition Effect: This is personally our most challenging bias, defined as retaining an investment that loses value for too long or too quickly selling an investment that does well. As investors with a value orientation, we are inherently early to an investment idea. Balancing an acceptance of being too early against holding onto a bad idea is difficult, to say the least. And, being value conscious, we’ve struggled at times to “let our winners run.” The best defense again disposition is to have a strong “sell discipline.” In a nutshell, we’ve developed specific criteria to attempt to identify an overvalued business (significantly more expensive than the market) or a business whose model is irreparably impaired (a “value trap”).
One major benefit of enlisting professional financial advice from experienced advisors is that we have a good deal of self-awareness and personal insights around these biases and we comprehend the strong emotional pull they have on investment decisions. While investor biases aren’t completely unavoidable, their damage can be minimized as we implement multi-decade investment plans to achieve long-term financial goals.
Please visit www.atwatermalick.com/ria for full disclosure materials related to recommendations contained in this update.