“We have met the enemy, and he is us.” -Pogo
Few would argue that objectivity toward the various options in a wealth management plan is not valuable. Yet many articles and books have been written about bias’ that individuals bring to the table when constructing a overall wealth management strategy with a high probability of successful outcomes. Two academics who have written extensively on the subject of behavioral economics are Richard Thaler and Daniel Kahneman.
Bias and Behavior
While many would acknowledge they may have a bias occasionally, the frequency and impact of an investor bias is often difficult to see in oneself. There are six common and widely discussed investor biases:
Overconfidence: At first blush, confidence seems like a good thing. When one is confident in their ability to make good investment decisions, it is not uncommon to focus more on the upside and the good outcomes of an investment, and diminish the possible negative outcomes. While confidence is necessary to move forward, discounting the negative side can have dangerous consequences.
Hindsight Bias: Less than optimal investment opportunities happen to all investors. The hindsight bias is often exemplified by a feeling of “I knew better than this”, despite the fact the information was not known at the time. The often misplaced feelings of regret lead to avoidance of similar situations even when the situation has a different set of factors. This avoidance likely leads to missed opportunities over time.
Short-Term Focus: In my experience, most investors claim to be long-term investors, that is, until a short-term pullback presents itself. On many occasions, I have observed that market bottoms are accompanied with the largest number of calls from clients concerned about the market. Each time, the phrase “it’s different this time” is voiced. Yet, the commonality is that the short-term focus is clearly in effect. Short-term focus is the reason people consistently sell at the bottom of a market, enabling a permanent impairment of capital. Of course, this is not helpful in building and preserving wealth.
Regret: This bias has similarities with the hindsight bias in that the investor places more emphasis on possible regret that is yet to manifest, preventing an objective view of the current opportunity. They often remark “this investment went bad and this new one might too.”
Mental Accounting: Investors tend to look at their investments as pieces rather than the portfolio as a whole. This often leads to over-estimating and/or under-estimating portfolio performance rather than objectively assessing overall results. This can lead to assessing performance in a vacuum and heightened concern about risk in a portfolio. As referenced in part two of this series, focusing on the pieces rather than the whole can skew investment judgements in an unproductive manner.
Hot Hand Fallacy: Investors like to see success and picking last year’s winning stock or a hot manager seems be a trend for investors. One of the human species unique talents is identifying patterns, and often it serves them well. Investing, however, is much different than staying away from the sabre tooth tiger or keeping their hands off of a hot stove or a fire. Inferring pattern in random investment market returns often leads to less than desired outcomes. In fact, often the best outcomes come from recent poor performance and trends. Chasing performance rarely leads to the outcomes desired.
Investor bias is an easy thing to have and not recognize. Teaming up with an advisor acting as your Personal Chief Financial Officer can provide a diverse set of options and serve as a sounding board and coach to avoid the inevitable mental traps that lay in an investor’s path.