Warburton Capital’s Evidence-Based Investent Insights

Behavioral Biases – What Makes Your Brain Trick?

Installment Twelve

So, a buddy comes in. The entertainment of the day for our recently retired buddy had been CNBC – or ‘Financial Pornography’ as we characterize it. Having ‘Drunk The Kool-Aid’ our buddy was now convinced the Government Shutdown was going to ruin life as we know it. Maybe? Probably Not? Our Economy is and lifestyles are influenced by hundreds of millions of individual daily contributions to Private and Public Enterprise. Of course, our Government takes ‘A Cut’ for the collective services provided. Will ‘Life As We Know It Be Ruined’ if it takes our Government a few days, weeks or even months to find common ground? Maybe! Probably Not!

That said, welcome to this the twelfth installment in Warburton Capital’s series on Evidence-Based Investment Insights: Behavioral Biases – What Makes Your Brain Trick?

In our last piece – The Human Factor in Evidence-Based Investing – we explored how our genetically embedded ‘Fight Or Flight’ instincts generate an array of behavioral biases that lead us to make significant mistakes – many of which are money-management related. In this installment, we’ll explore a half dozen of the more potent biases and how you can avoid sabotaging your uniquely personal and purposefully derived life plans and investment plans by recognizing the signs of a behavioral booby trap.

Behavioral Bias #1: Herd Mentality: Herd mentality is what happens to you when you see a market movement afoot and you conclude that you had best join the stampede. The herd may be hurtling toward what seems like a sure thing, such as an appreciating stock or stock market sector. Or it may be fleeing a widely perceived risk, such as a country in economic turmoil. Either way, as we covered in a previous installment – Ignoring the Siren Song of Daily Market Pricing – following the herd can put you on a dangerous path toward buying high, selling low and incurring unnecessary expenses en route.
Behavioral Bias #2: Recency: Even without a herd to speed your way, our long-term plans are at risk when we succumb to the tendency to give recent information greater weight than the long-term evidence warrants. From our earlier piece – What Drives Market Returns? – we know that stocks have historically delivered returns superior to bonds. And yet, whenever stock markets dip downward, we typically see recency at play, as droves of investors sell their stocks to seek ‘Safe Harbor Assets’ – or vice-versa when bull markets on a tear.
Behavioral Bias #3: Confirmation Bias: Confirmation bias is the tendency to favor evidence that supports our beliefs and gloss over that which refutes it. We’ll notice and watch news shows that support our belief structure; we’ll skip over those that would require us to radically change our views if we are proven wrong. Of all the behavioral biases on this and other lists, confirmation bias may be the greatest reason why the rigorous, peer-reviewed approach we described in – The Essence of Evidence-Based Investing – becomes so critical to objective decision-making. Without it, our minds want us to be right so badly, that they will rig the game for us, but against our best interests as investors.
Behavioral Bias #4: Overconfidence: Garrison Keillor made overconfidence famous in his monologue about Lake Wobegon – ‘Where All The Women Are Strong, All The Men Are Good Looking, And All The Children Are Above Average’ Keillor’s gentle jab subtly reflects reams of data indicating that most people (especially men) believe their acumen is above average. On a homespun radio show, impossible overconfidence is quaint. In investing, it’s dangerous. It tricks us into losing sight of the fact that investors should expect to consistently outsmart the collective wisdom of the market, as we described in – You, the Market and the Prices You Pay – especially after the costs involved.
Behavioral Bias #5: Loss Aversion: As a flip side to overconfidence, we also are endowed with an over-sized dose of loss aversion, which means we are significantly more pained by the thought of losing wealth than we are excited by the prospect of gaining it. As Jason Zweig in “Your Money and Your Brain”¹ states, “Doing Anything – Or Even Thinking About Doing Anything – That Could Lead To An Inescapable Loss Is Extremely Painful.”

One way that loss aversion plays out is when investors prefer to sit in cash or bonds during bear markets – or even when stocks are going up, but a correction seems overdue. The evidence clearly demonstrates that you are likely to end up with higher long-term returns by at least staying put, if not bulking up on stocks while they are ‘Cheap.’ And yet, even the potential for future loss can be a more compelling emotional stimulus than the likelihood of long-term returns.

Behavioral Bias #6: Sunken Costs: We investors also have a terrible time admitting defeat. When we buy an investment and it sinks lower, we often tell ourselves we don’t want to sell until it’s at least back to what we paid. In a data-driven strategy – and life in general – the evidence is strong that this sort of sunken-cost logic leads people to throw good money after bad. By refusing to let go of past losses – or gains – that no longer suit your portfolio’s purposes, an otherwise solid investment strategy becomes clouded by emotional choices and debilitating distractions.

Our Take-Home: So, there we have it. Six behavioral biases, with many more worth exploring in Zweig’s and others’ books on behavioral finance – not to mention my future book – ‘Behavioral Based Wealth Management’.

We recommend you take the time to learn more. First, Behavioral Finance Is A Fascinating Field Of Inquiry. Second, Knowing Yourself Can Help You Become A More Confident Investor. As a bonus, the insights may enhance other aspects of your life as well.

Be forewarned. Even once you are aware of your behavioral stumbling blocks, it can still be devilishly difficult to avoid tripping on them as they fire off lightning-fast reactions in your brain well before your logic has any say. That’s why we suggest you should work with an objective fee-based advisor who operates as a fiduciary – it doesn’t have to be us – to help you see and avoid collisions with yourself that your own myopic vision might miss.

In the next and final installment of our Evidence Based Investment Insights, we look forward to tying together the insights shared throughout the series. Of course, there’s no need to stand on ceremony. If you have questions or ideas you’d like to explore right away, feel free to reach out to us today.

Trusting you aren’t losing sleep over the Government shutdown and are inspired with confidence by your uniquely Personal/Purposeful Financial Plan, I remain – on behalf of our firm

Yours truly,

Warburton Capital Management