Behavioral finance or how NOT to be your own worst enemy when it comes to money

And there’s a plethora of research to prove it, dating back at least in the modern era, to 1979 when Daniel Kahneman’s and Amos Tversky’s paper, Prospect Theory: A Study of Decision Making Under Risk, was published. Their research uncovered the loss aversion bias.

In the years before and after that landmark paper was published, numerous other biases have been identified. And, at a minimum, you should have a working knowledge of some of the more common biases, how to spot them, and what you can to avoid or mitigate these biases.

Recency bias

Investors tend to focus on recent returns and current trends instead of incorporating a more complete universe of historical data, John Nersesian, head of adviser education at PIMCO, wrote in a recent issue of the Investments & Wealth Monitor.

And often, they assume those returns and trends – think bitcoin, which was up about 322% for the 12 months ending June 15 — will continue. “This can lead to portfolio decisions that are driven by emotion and inconsistent with investors’ risk tolerance and long-term financial goals,” he wrote.

You don’t have to search far and wide to find more examples of recency bias, either. For instance, investors buying mutual funds and ETFs that have produced the largest near-term returns, while potentially ignoring those investment options with greater long-term records that might afford greater value in the current environment, is perhaps the most common example of recency bias, said Nersesian.

And those who suffer from this bias stand to lose a great deal of money. “Recency bias may be the greatest contributor to the difference between market returns and the returns earned by individual investors, as it often leads to behaviors to buy high and sell low,” said Nersesian. “Remember that successful investing is often counterintuitive: adding to positions when it feels uncomfortable and managing emotions when the environment is euphoric.”

How best to spot this bias? Do you find yourself chasing hot stocks, mutual funds, ETFs, and other types of investments (bitcoin) without understanding the actual investment characteristics? Are you the type of investor who gains confidence based on your recent successful trades despite a mediocre long-term record? Then you’re prone to recency bias.

How best to counter this bias? Nersesian recommends the following: Look at a larger data set, longer time frame, and avoid the temptation to use only recent returns; look at the volatility of asset class returns, and the challenge of predicting them, using the so-called periodic table of investment returns; learn how to identify your behavioral biases; and try to focus your attention on things you can control (risk, taxes, costs and behaviors) versus things you can’t (market returns).

Loss aversion

Adam Smith, author of The Wealth of Nations, noted back in 1776, that “Pain … is, in almost all cases, a more pungent sensation than the opposite and correspondent pleasure.” Or, as Kahneman and Tversky noted in their landmark paper: losses are weighed more heavily than gains.

And this aversion to losses can cause investors, according to Nersesian, to sell winning investments too early, or to hold losing investments too long, or to invest in safe assets to avoid the possibility of loss.

How to spot it? According to Sarah Newcomb, director of behavioral science at Morningstar, loss aversion is that familiar, recoiling feeling at the mere thought of failure or loss. “It’s very similar to risk aversion, and so the same behaviors can be symptoms,” she said. “Do you have cash sitting in low or no-interest accounts because the thought of seeing the balance drop during a market slump is more painful than the idea of watching the balance grow? That could be loss aversion talking.”

How to counter it? Newcomb recommends reminding yourself that losses are a regular part of every successful investor’s experience. “It isn’t a sign of bad decisions, it’s simply a byproduct of volatility,” she said. “You can help ease the fear of losses by making sure you’ve properly diversified your investments. If you are especially loss averse, having an emergency fund that is in Treasurys or other safe investments can help you rest assured that even when moderate market losses happen, you’ve got plenty of solvency in the short and medium term to get you through.”

Confirmation

With confirmation bias, investors tend to seek out and more easily believe sources of information that agree with what we already think, said Newcomb.

“It’s much more psychologically costly to seek out or soak in information that challenges our current views, so instead we scan the environment for evidence to support what we already think or believe,” she said.

According to Newcomb, you can spot confirmation bias by watching your information search habits. Do you scan headlines for views that ‘prove’ your opinions? Do you search for info on investments that backs up your favorite strategies? Or do you intentionally search for counterpoints to your own views so that you can make your approach as strong as possible? Do you try to think of ways to fill in your blind spots?

What are some ways to counter confirmation bias? Newcomb recommends trying new websites and news sources. “Find a writer or commentator who is smart but holds a different view and open your ears to them,” she said. “Even if you wind up sticking to your original view, you will most likely have stronger reasons for doing so as a result of welcoming and weighing alternate perspectives.”

Familiarity

This behavior occurs when individuals have a fondness for familiar investments despite the clear benefits of diversification, said Victor Ricciardi, a visiting finance professor at Washington and Lee University and co-editor of Investor Behavior and Financial Behavior.

“People reveal a strong desire for owning local stocks that they are more familiar with, which is known as local bias, and overly invest in portfolios with domestic securities, which is known as home bias,” he said. “This results in investors holding overly concentrated and under-diversified portfolios.”

Others share this point of view. “We are more comfortable with what is familiar and close than what is unknown or far away, so it can feel safer and more comfortable to invest in domestic securities than to venture into the waters of foreign companies and funds,” said Newcomb. “This can lead to ignoring great opportunities because they aren’t close to home.”

How to spot it? Newcomb recommends examining your portfolio. What percentage of your holdings are domestic?

How to counter it? Ask yourself the following questions: Do you really think that your home country represents the only worthwhile opportunities for growth and investment? What other areas around the world do you think might be developing in ways you could get on board with?

Also, talk to your financial adviser and start reading up on global business trends. “You might find some very exciting opportunities abroad that can complement your domestic investments nicely,” Newcomb said.

Anchoring

Anchoring is a bias in which our decisions are subconsciously influenced by some other piece of information, according to Jay Mooreland, the founder and president of the Behavioral Finance Network. “This information is a reference point, an anchor from which we form expectations and decisions about the future,” he said.

Consider, for example, the adviser who tells their client that they expect to achieve a 6.5% annual rate of return over the long term. “Such a statement is often the result of financial analysis and may be completely accurate,” he said. “The problem is that the 6.5% has become an unintended anchor. Now the client is expecting a return of 6.5%, regardless of time horizon.”

But if the market were to drop 25% in a quarter, and the client is subconsciously anchored to a return of positive 6.5%, they will get an unwelcome surprise, said Mooreland. “Such negative performance is not in line with the expected 6.5% return and may signal to the investor that something is wrong, and they need to get to safety.”

Advisers can embrace anchoring by using it to set expectations. “They can certainly state that over time the client is expected to earn an average of 6.5% annual return, but they should also provide additional ‘anchors’ to help investors get through the short term,” Mooreland said.

The adviser could state, for instance, that such a portfolio in the short term could fluctuate between, say, -35% and +55%. “This way they have given the long-term information, but understanding how anchoring works, could provide short-term anchors as well, because we know investors, even long-term investors, are influenced by short-term performance,” said Mooreland.

Most human decision-making is based on comparisons, Newcomb pointed out. “We like to compare options or look at possible outcomes relative to a reference point,” she said. “Anchoring happens when we mentally attach the value of something to a specific reference point, the anchor.”

The problem with anchoring and adjustment is that sometimes the reference point we anchor on is inappropriate, and sometimes we don’t adjust enough, said Newcomb. “For example, some studies have shown that random numbers presented to participants can serve as anchors in subsequent decisions, biasing their answers toward the random number,” she said.

How to spot it? This one can be hard because we make most decisions based on some reference point, so determining if you are anchoring on an appropriate reference point and figuring out if you are adjusting appropriately can be difficult, said Newcomb.

How to counter it? One way to counter anchoring bias is to set your own price point based on carefully chosen data before getting into a buying environment.

“If you were shopping for jeans, you might set your budget before you head out based on what you think is reasonable and affordable so you’re less likely to anchor on the prices presented to you at the store,” said Newcomb. “In the case of investments, you’d want to set your expectations about fees, price, and returns based on careful research before entering the sales environment of an advice firm or brokerage website.”

Inertia/Status quo

Many investors, especially retirement savers suffer from status quo bias in which they default to the same decision or accept the current situation, said Ricciardi.

“Status quo bias happens when investors fail to modify or update their investment decisions despite the potential benefits,” he said. “For example, people fail to save for retirement, never meet with a financial planner or do not actively monitor their investment portfolio.”

For her part, Newcomb said “better the devil you know than the devil you don’t” is the root of status-quo bias. “Even when we are uncomfortable with the current situation, we often prefer the familiar to the unknown,” she said. “Status-quo bias behaves a lot like inertia because it can lead us to continue behaving in a particular way even when that course of action isn’t ideal.”

Psychologically, she said, it often hurts less to maintain course than to change simply because we are so uncomfortable with uncertainty. “Some studies suggest that we actually prefer physical pain to the emotional/psychological pain of uncertainty,” said Newcomb. “This can lead us to follow familiar paths even when they are sub-optimal financially just because they are less costly psychologically at least, in the short run.”

How to spot it? Are you sitting on a pile of cash because you’re not quite sure where to invest it? Have you been meaning to revisit your asset allocation, but just haven’t got around to it? “Procrastination and status-quo bias are close bedfellows, said Newcomb. “Since change makes us face up to uncertainty, we often just keep going as we have been going.”

Investors who fail to monitor their portfolios and/or meet with a financial planner on a regular basis are displaying inertia about their financial decisions, Ricciardi said. 

What to do about it? Count the cost of inaction, said Newcomb. “Cash holdings lose money through inflation,” she said. “Failing to rebalance can leave your portfolio to drift dramatically away from your intended strategy. Inaction is action.”

And, if you’re afraid of making a mistake by taking too drastic an action, then at least ask yourself (or your adviser) if there is a small step you could make to improve your balance sheet just a little. Said Newcomb: “Instead of cash, could you put those funds into high-interest savings or inflation-linked bonds, for example? You don’t have to swing wildly away from the status-quo, but if inaction means losses, then even small action can benefit.”

Overcoming this bias also requires strong inspiration and incentives, said Ricciardi.

Overconfidence

Individuals exhibit a tendency to overestimate their skills, knowledge, abilities and chances of success, said Ricciardi. “The result of overconfidence is excessive trading, poor investment returns, and failure to appropriately diversify investment portfolios. These types of individuals are traders and not investors.”

How to spot this bias? Do you assess your investment abilities as above average? “For example, if a person was told the average return for an asset class is 8% per year, if the individual expects a 12% return for the next year this might reveal overconfidence,” said Ricciardi.

Another question: Do you trade excessively compared with the average investor? Often, those who suffer from overconfidence will have a very high portfolio turnover rate for their investments, said Ricciardi.

To overcome this bias, investors should frame their portfolio as a “long-term bucket” that is for financial goals such as retirement, said Ricciardi. “This type of bucket should be viewed as a ‘buy and hold’ approach rather than as a trading account,” he said. “Remind yourself not to chase short-term returns based on the emotional aspects of the current market, financial news and social media.”

More ways to counter behavioral biases

Overcoming biases requires learning about the different investment biases you might suffer from, said Ricciardi. “Having the ability not to engage in bad financial behaviors and to limit investment mistakes; this entails developing and following a nonemotional, objective investment strategy,” he said. “Individuals should invest for the long term, identify their level of risk perception and risk tolerance, decide upon a suitable asset allocation strategy, and rebalance portfolios yearly. Lastly, meeting with a financial professional to develop financial objectives and administer a financial plan will result in a lifetime of financial wealth and options.”

Others share this point of view. 

“Spotting anchoring, or any behavioral bias in ourselves, is near impossible in the moment,” said Mooreland. “That is why having an adviser or trusted friend that understands the psychology of decision making can help. The best way to manage/mitigate it is to ask more questions and obtain more information – which we are naturally averse to. We generally want the quick, intuitive response without analysis. That is why many people get trapped into these biases and continually make unwise decisions.”