Behavior Bias and Investment Planning

In recent years the field of behavioral finance has been expanding at a rapid rate.

For years, stock market hypotheses and analysis focused on the quantitative formulas that surround risk and return-these analyses treated markets as “efficient” meaning human behavior does not explain valuations, risk, nor returns in the capital markets.  

While this pursuit has produced Nobel prize winners for econometric models, it left out the most important determinant in portfolio returns-human behavior.  How we act and react in relation to our financial profile has a far greater impact on our returns than any market-based hypothesis.

 Since we are humans driven by emotions, we acknowledge all decisions, at their core, are strongly driven by our emotions.  We have biases built into our emotional base.  These biases can often act against our future prosperity in investment planning when we let them guide our decision making.  We will look at five common biases that can be the enemy of the investor.

 1) Confirmation bias:

The investor who looks for information to confirm a belief or theory, while disregarding information that may refute their belief.  Many of the media networks at this point are not news-driven, rather, they are affirmation networks, attempting to reinforce the views of their watchers.  This bias deludes the investor in the sense that he can not be wrong, and may force decisions to hold on to investments that fail.

2) Recency bias:

This bias builds in the belief that the future will always be like today or yesterday.  This bias is especially present at market extremes-be it the tech bubble of 2000 or the financial crisis of 2008.  We are getting a share of this today as we deal with the Covid crisis- that we know will end at some point.

3) Familiarity bias:

This occurs when investors have a preference for familiar or well-known investments despite the seemingly obvious gains from diversification.  This can lead investors to chase the current hot trend (that will surely end), bringing greater risk and suboptimal returns to their portfolio.

4) Overconfidence:

The belief we are better at something than we actually are.  One admirable feature about Warren Buffet is his lengthy and consistent acknowledgment of his mistakes in his annual reports.  This type of humility is uncommon among money managers (as well as many other professions).   It is built into our human nature to wash over our mistakes and let our successes take center stage-(who wants to talk about failure?)

This can be very damaging to investment returns as we may miss the incredibly valuable lessons we learn from our errors.

5) Worry/Loss Aversion

Worrying is natural.  Worry creates visions of what can go wrong and can blur our outlook and behavior in destructive ways.  It is said the market climbs a wall of worry-has there ever been a time when the crisis de jour was not on us or coming?  Yet, through all the ongoing travails of life, stock prices inevitably have moved higher (more people buying goods and services at increasingly higher prices -propelling corporate earnings, dividend increases, and share price growth).  We must remember, the most attractive times to invest are when the economic circumstances tend to be at their worst, and market prices have plunged.

As Warren Buffet says, be fearful when others are greedy, and greedy when others are fearful. Is it easy? No. Is it profitable? Highly.

As we become familiar with and alert to these biases, we will likely become better investors, and hopefully, less worried ones.