I have been around a lot of kids, at church, in the grocery store and other public places and I have come to the conclusion that my grandkids are the absolute best. They are well-behaved, good-looking, considerate, respectful, loving, obedient … should I keep going? Let us face it; some rug-rats are just that, but not my offspring. Now, you may say that I am partial and not objective and I ought to leave the judging to someone else. “I am not bias!” I retort. (And I do not have any blind spots either; I checked and there was nothing there!)
All of us have biases and it is best that we recognize them and I should acknowledge my bias when it comes to comparing my grandkids with other children. I also need to realize that I can disproportionately judge in favor of or against various beliefs, ideas or people in many different situations. Unfortunately, we are all subject to that dilemma.
Our personal biases also affect the way we invest or should invest…Have you ever stopped to realize that? Your bias may keep you from doing what is best. From the field of behavioral finance, here are four investment biases:
If you ask a child whether he wants $5 today or $20 next month, which do you think they would pick? They may choose the lower valued greenback now because it is closer to the present and provides instant pleasure. But that impatience in decision making is not just limited to children or adolescents. A recent study from the National Bureau of Economic Research, showed that 55% of respondents would also choose to pocket less money now, than more money in the future.
Many adults have that “feel good now” and “you only live once” mindset, a desire to experience immediate gratification instead of reaping a greater future reward. This present bias is associated with borrowing and undesirable spending. It shows that we can be enticed to make a purchase now instead of investing for the future. However, patient investors not only settle for delayed gratification but have more money over time.
Personal question: is it better to not lose $100 than to find $100? This cognitive bias refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains. In their 1979 book, titled Prospect Theory. An Analysis of Decision Making Under Risk, Daniel Kahneman and Amos Tversky coined the phrase, “losses loom larger than gains.” Loss aversion suggests that for some folks the pain of losing is psychologically twice as powerful as the pleasure of gaining.
So, when markets pull back or seemingly crash (can anyone say March 2020?), some retreat to cash instruments as a way of avoiding further decline in investment value. But that perceived safety, triggered by fear, anxiety and/or panic, can have a profoundly negative effect. Because one’s investment fell short of expectations in the past, avoiding risk completely in the future can derail their financial plan and delay their long-term goals.
The Summer Olympics was supposed to be contested this year but because of COVID-19 it has been postponed until July 2021. During either the Summer or Winter Olympics you may have a certain individual or event you enjoy observing. At times it is fun to cheer for the underdogs, like the Jamaican bobsled team, or to see the grace of a particular gymnast or ice skater, but no doubt most of the time you probably root for team USA. Imagine putting together a “dream-team” of the best-of-the- best from each country (can anyone say, “Fantasy Olympics?”) and having them compete against all the other nations.
Sometimes our home-team bias also creeps into our investment choices. We just stick with domestic companies or funds overlooking international ones that could also enhance our portfolios. Putting together that “dream-team” of global investments bodes well for diversification and over time generally leads to better risk-reward trade offs.
Herd Mentality Bias
Do you remember your parents warning you about peer pressure when you were growing up? They scolded you when you got yourself into trouble because you followed the crowd and did the wrong thing. It is emotionally and psychologically hard to go against the “wisdom” of the “herd!” Instinctively, we can believe that when most people are doing something, it must be right. That is why certain political polls are touted prior to elections so public opinion can be swayed; everyone wants to pick the winner.
Unfortunately, that “everyone else is doing it!” also creeps into investment decision making where we follow and copy what other are doing. We are “hardwired” to herd and can be predominately influenced by instinct or emotion and invest money the way other people do at any given time. And history is replete with this herd mentality bias. There was Tulip mania in the Netherlands in the 1600’s. The Dow Jones Industrial Index was up 300% in the roaring 20s (1924-1929) only to come crashing down in 1929 by almost 50%. Then there was the dot.com bubble in the 1990s. Many dot.com companies did not have sound business models, but “investors” (or should I say speculators) bought into them anyway because everyone else was and we all know how that ended!
When bubbles do pop and the crash is over, how many ask themselves, “what was I thinking?” and learn from those experiences. It is best to avoid investment fads, learn about opportunities the “herd” overlooked and do your own independent analysis.
These are just four of the many biases that cause decision-making errors. Additionally, there is anchoring bias, availability bias, confirmation bias, hindsight bias and more.
So, what biases do you have? Take a step back and objectively assess how they have impacted your investment strategy. Are you working with someone that can help you answer that question and keep your biases from overruling prudent choices? A competent financial advisor will listen to your needs, concerns, opportunities, time frame, goals, etc. and design an appropriate plan to navigate the ups and downs of the market while keeping your biases in check. You will discover that a long-term relationship with such a trusted advisor is the best … just like my grandkids!