Traditional financial theory assumes investors are rational, markets are efficient, and returns are determined solely by the risk level of an investment. From these assumptions, the natural conclusion is that a portfolio’s investment return is directly, and wholly, related to the portfolio’s allocation between stocks and bonds.
In recent years, behavioral finance has begun to amend these assumptions to reflect more real-world human actions and apply findings from psychology and sociology. Specifically, behavioral finance has challenged the notion that investors are always rational. On the surface, this seems like a fair assumption. It makes intuitive sense that investors prefer more wealth to less and should, in theory, be indifferent to the source of wealth. In practice, however, “normal” investors are subject to pernicious cognitive biases that influence decisions and, ultimately, investment returns – usually for the worse.
These biases are appealing because they help us make decisions more quickly, and we are wont to take the path of least resistance to a solution. It would pay dividends (literally and figuratively) to take a step back and examine our decisions to make sure that we are acting in alignment with our predetermined values rather than using these shortcuts.
The first step to combating the biases is recognizing them. Here are a few of the most common biases to look out for when determining your investments:
- Affect Bias
This bias is a mental shortcut in which people judge something as good or bad based on their emotions. We see this often in the connotation of certain words. For example, the words “meticulous” and “picky” evoke very different responses even though they are technically synonyms. The same emotive response can happen with investments as well. During the Dot-com bubble at the turn of the century, many companies capitalized on this bias by adding “Com” or “Net” to their name. Companies like WorldCom and Netscape used the name to garner investments and stock prices soared, even as the companies themselves sputtered. Next time an investment piques your interest, make sure to ask if you like this investment because it is sound, or if you think it’s a good investment just because you like it.
- Confirmation Bias
Confirmation bias has a long and storied history in numerous fields. It is the process of selectively interpreting information in a way that confirms preconceived notions. Any information that challenges the already-held opinion can be rationalized or ignored. In the investment world, investors are slow to change first impressions. An initial good impression of a company may be caused by the investor’s emotions or a tip from a friend. Knowing not to use the affect bias shortcut, the investor does some research about the company to gain a more rational understanding of the stock price. Subconsciously, however, the investor will highlight the articles that present favorable information and dismiss those that offer negative views of the company, reinforcing the skewed opinion and potentially leading to a poor decision.
- Herding Bias
This bias is self-explanatory. People are influenced by the decisions around them and tend to make conforming decisions, even if the individual may have chosen differently. The shortcut of this thinking is, “If it’s good enough for the group, it’s good enough for me.” It also has to do with our innate desire to be accepted into a larger group. As it pertains to investing, a stock price may increase solely due to a herd increasing demand for that stock. This begins an upward cycle in which more outsiders see the price increase and jump on the bandwagon, pushing the price up even further. Eventually, the bandwagon reaches capacity, the stock price corrects itself, and the last buyers are left in an unenviable financial position.
These are just a few of the many behavioral biases that may affect investment decisions and returns. Knowing that these exist can help avoid them. An objective third-party can also help discuss investment ideas and ensure that your portfolio is allocated in conjunction with your goals and values.