From Hebert’s “Left Brain Investing in a Right Brain World”
It should be no secret that investors have behavioral biases, after all the one thing we investors have in common is that we’re humans. And humans have biases, whether we recognize them or not.
Behavioral biases are mental shortcuts that occur, often unconsciously, when making judgements or decisions. That shortcut allows an easier or quicker path to a decision, typically not including additional research to support the decision. We go forth because we think the path is right, not necessarily because we’re more informed.
Shortcut biases follow us around in everyday life as well attaching themselves to our investing decisions. Not all biases affect us the same, some result in minor, or not so minor, consequences. While your personal life may suffer from bias behavior, investing bias can literally wreck your finances.
An easy way to pay yourself dividends, emotionally and financially, is to recognize and counteract biases and hopefully avoid unpleasant consequences.
Highlighted below are three prevalent biases of the roughly 20 known behavioral investing biases.
Loss Aversion Bias:
People generally experience the pain of loss more than they do the pleasure of gain. Numerous studies on loss aversion have quantified a general rule of thumb: Psychologically, the possibility of a loss is twice as powerful as the possibility of making a gain. About a two to one ratio. Loss aversion causes investors to hold losing investments too long and sell winners too early. Loss aversion will cause this investor to be overly cautious, second guessing their decisions, often resulting in no action.
Overconfidence Bias:
Investors with unwarranted faith in their judgements, reasoning or mental abilities are described as overconfident. This investor will overestimate their ability to evaluate companies or stocks as potential investments. They will trade excessively due to the belief they possess special abilities. This investor will vastly underestimate the downside risks of investments and be surprised when that risk is realized. Overconfident investors think they are smarter than their results indicate, feeling superior to the market and other investors. An overconfident investor is an accident waiting to happen.
Availability Bias:
Availability bias is a mental shortcut people use to favorably estimate an outcome based on how prevalent or familiar that outcome appears in their lives. Investors with this bias choose investments based on information available to them now. Judgements are based on readily available information, not necessarily complete information. Repetitive advertising, suggestions from friends and family, or the cocktail party “hot tip” are in favor with this investor. Proper research will be an afterthought. The more available information is, right or wrong, the more influence it will have, and less analysis will be applied by this investor. The more you hear or see something doesn’t make it a better investment.
You’ve probably noticed a common theme running through this investing bias topic. A data centric or analytical process is noticeably absent when bias oriented investors make investment decisions. More damage has been done to investment portfolios by following the fickle twins of emotion and subjectivity than by any other process.
What does it take to reduce or avoid this potentially harmful investing behavior?
- Realize that emotion and subjectivity can easily affect your decisions. Your task is to try and eliminate that influence as much as possible. Shortcuts will often cause financial distress.
- Recognize that there is a mathematically correct way to make an investing decision. Solid data analysis properly applied works. Reliable and factual research leads to more informed decisions.
- Craft an investing plan with measurable points as your decision base. Basic concepts include broad diversification, thoughtful asset allocation, and individual stock price points for proper entry and exit.
- Diligently follow the plan and review periodically to ensure it fits your goals and risk tolerances.
- Engage a disciplined investment manager to perform this customized work for you.
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