Undermining Investment Success: Pitfalls Caused by Behavioral Bias

Undermining Investment Success: Pitfalls Caused by Behavioral Bias

By A. Scott White, CFP®, ChFC®, CLU®
President, Scott White Advisors

It’s natural to have an emotional reaction to news about the market. Behavioral scientist Nina Mazar, professor of marketing at Boston University School of Business, studies investor biases—why individuals react the way they do. Mazar says biases are hard to control because they predominantly happen unconsciously and automatically, and they affect all of our decision-making. But when it comes to investment decisions, Mazar says behavioral biases can have a significant impact an investor’s quality of life.

According to Mazar, there are 4 primary behavioral biases that affect investors:

  1. Loss aversion. Studies have shown that for the human brain, losing something is twice as painful as the pleasure experienced from gaining the same thing. The loss aversion bias can cause investors to overweight losses relative to gains and can result in them being overly fearful and risk-averse. Investor feelings of fear, pain from a prior experience, or indecision can result in lack of effective action.
  2. Overconfidence. Mazar says overconfidence is one of the most dangerous biases when it comes to investing and may contribute to excessive rates of trading in the stock market, and it can result in overly risky decisions and poorly diversified portfolios.
  3. Anchoring. According to Mazar, investors tend to rely too heavily on the most salient information, such as the last high or low price of a stock. Once that information is locked in the brain, it’s hard for an investor to adjust their opinion to recognize any new information.
  4. Pattern-seeking behavior. Mazar says this is the human tendency to look for meaning and trends in even the most random patterns — and to act on this faulty observation. For example, an investor may infer that a fund is above or below average based on historical information—and predict a continuation of this performance.

As a financial advisor, I understand behavioral biases. Sometimes I hear from clients who wonder how the latest stock market news may affect their portfolio. Sometimes they tell me they’ve lost sleep worrying about it. My reaction is to understand how the bias of loss aversion may be affecting my clients.

At times like those, my job involves reassuring clients that the investment strategy we have created does not involve trading stocks. Instead, our strategy places our future in the world’s brightest, most talents minds who run the world’s most profitable businesses. Mankind’s ability to produce goods to satisfy human wants is the essence of our investment strategy.

To own these profitable businesses we buy stock in their companies, and that stock trades in the stock market. But not all people who buy these stocks are investors. Instead, a large percentage are speculators, not buying stocks to own the world’s most profitable businesses, but instead wagering on whether a stock price might go up or down based on things that may or may not happen, such as falling interest rates. In many cases, these speculators know very little about the business of the companies whose stock they are buying and selling.

But as investors, we understand that pursuing a strategy based on events that may or may not happen is very tricky because of all the things we cannot control, such as natural disasters and geopolitical events. Those are not nearly as predictable as the certainty that if a corporation is compounding profits over a long period of time, it will surely push its stock price higher due to the intrinsic rising value of the business.

As Mazar’s research shows, humans are emotional creatures and we are unconsciously affected by biases. What can be more emotional than watching the value of your life’s work—the balance in your investment account, IRA, or 401(k)—go up or down? We all enjoy the positive emotional experience of seeing the value rise and want to avoid the emotional pain of a declining balance. But as investors, we can separate the short term unpredictability of stock prices versus the long term certainty that those prices historically and predictably reach new highs.  The short term price movement in stocks is created by speculators in the market—and that movement doesn’t affect our long term strategy.

So what is Mazar’s recommendation to help ameliorate common investment behavioral biases? A skilled financial advisor who is aware of the pitfalls caused by those biases. Mazar says an advisor can help investors make better informed and more objective decisions—while supporting them to take steps to minimize the influence of investment biases. With the help of a financial advisor, she says, investors can learn to stop undermining their own financial success.