Behavioral finance is the study of how biased thinking can impair our ability to make good investment decisions. It helps to be aware of our financial biases and develop strategies to overcome them in order to become better investors. Here are some of the more prevalent biases along with some ideas for keeping them in check:
Overconfidence
In most common pursuits, such as driving, the majority of people believe that they are above average, which is statistically unlikely. This leads to a common misconception among investors that they are skilled stock pickers, when, in fact, even elite institutional portfolio managers have trouble selecting stocks that consistently beat the market averages. Consequently, most individual investors should avoid wasting time trying to pick attractive stocks and focus instead on strategies that add value, such as sound asset allocation.
Hindsight bias
Past events, including market peaks and troughs, often seem easily predictable with the benefit of hindsight. This leads investors to believe they can pick the next market rally or correction. In truth, market timing is nearly impossible to get right on a consistent basis; a long-term buy-and-hold strategy is far more likely to succeed.
Familiarity bias
Familiarity tends to give us a false sense of control. Many investors hold concentrated positions in companies or industries they know well. As a result, they are exposed to specific risks affecting that industry, which could easily be diversified away. Broad global diversification across multiple asset classes is usually a better strategy.
Regret avoidance
This behavior causes us to avoid decisions that are likely to cause future regret. In investing, we tend to focus on bad outcomes and blame the decisions that led to those outcomes. A loss in your stock portfolio is a bad outcome, but that does not mean that you should avoid investing in stocks. Successful investors realize that a disciplined approach and a long-term perspective will help overcome the occasional bad outcome.
Extrapolation
We have a strong tendency to base our investment decisions on recent market trends. If the market has been going up for a while, we assume it will continue to go up, and vice versa. This can result in a cycle of investment binging and purging, often resulting in buying high and selling low, a sure recipe for poor investment performance. A buy-and-hold approach usually earns higher returns than an attempt to time the market by extrapolating recent performance into the future.
Our behavioral instincts generally lead us to avoid situations that cause pain, an important survival mechanism. With investing, however, we often react to pain that has already occurred, leading us to avoid risk after a loss, or load up on risk after a gain, which can lead to poor results. Successful investing sometimes requires that we ignore, or at least override, our behavioral impulses. By understanding the more common behavioral biases, we have a better chance of recognizing them and making good investment decisions.
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital