- Avoid holding onto an investment based on its initial price or sentimental value
- Don’t hold onto an investment based on its initial price or sentimental value.
- Use your biases to counteract each other.
When it comes to personal finances, our intuition often leads us astray. The nature of intuition of course means that it’s not entirely our fault when things go wrong, but the remnants of our Stone Age brains can sometimes pose obstacles for solving complex modern financial problems. Enter behavioral finance.
Behavioral finance is a burgeoning field that explores systematic ways in which investors deviate from “optimal” choices with their money. Here are six of the more famous investor biases, as well as key strategies to overcome them.
1. The Endowment Effect
Have you ever owned something that you can’t bring yourself to part with? Perhaps a 10-year-old TV? Or that shirt you’ve hidden in the back of your closet? How about 1,000 shares of Google stock?
Humans have a hard time getting rid of things they own. The classic study examining this phenomenon involved handing out mugs to half of an undergraduate class, and giving the students the opportunity to buy and sell the mugs among themselves. Those who received mugs tended to require a much higher price to sell the mug than those who didn’t receive mugs were willing to pay, as you can imagine. Thus, few transactions occurred. Sound familiar?
Being “endowed” with something naturally gives it some amount of sentimental value, and often the owners value it more than they can sell it for. While this is relatively innocuous with a 10-year-old TV, it can really harm investors who own a concentrated investment position but refuse to diversify it. Owner beware!
2. Choice Overload
Imagine you walk into a store and there is a clerk handing out samples of jam in front of a display: raspberry, boysenberry, strawberry, blackberry, black raspberry, berrylicious, blueberry, cranberry, and goji berry, just to name the berry options. How many would you sample? How likely would you be to buy one?
Now imagine the same scenario except that there are only six jam options: raspberry, blackberry, strawberry, apricot, apple, and grape. How likely would you be to buy one now?
This was another classic experiment (though I made ip the particular jam flavors for this example), and the researchers found that people were much more likely to make a purchase in the six-jam scenario than the 24, and reported greater ultimate satisfaction with their choice.
In the finance world, 401k plans are the typical example of choice overload, where there are so many options that employees are actually less likely to participate at all! The moral of this story is that when making financial decisions, it often helps to limit your choice set to a few good options, rather than casting such a wide net that you get overwhelmed by the process and either make a rash decision or freeze and not make none at all.
3. Confirmation Bias
Do you know anyone who believes something so strongly that they ignore any evidence to the contrary? Do you hold any such beliefs? Of course not, only other people do!
This phenomenon is called the confirmation bias. In one study, participants were asked to state their stance on a particular social issue, and then read a balanced article about the issue. They were then asked whether the article supported their stance or an opposing stance. No matter which side the readers were on, they tended to report that the article was in their own favor! When asked to provide evidence, they pointed toward evidence that supported their stance but glossed over the rest.
The lesson here is that people naturally seek sources of information that support their beliefs and shy away from those that offer contrary evidence. What does this mean for an investor? It means we have a tendency to forget past mistakes in our strategy and instead focus on the successes, however few and far between. While this might make us feel better about ourselves, it is unwise to make investment decisions based on cherry-picked evidence. Rather, we should examine our investments from a more holistic standpoint, making sure to analyze what went wrong at least as often as we analyze what went right.
What does your Social Security Number (SSN) have to do with the price of a bottle of wine? Hopefully nothing, right?
In one study, participants were asked to think of the last two digits of their SSN, and then instructed to estimate the value of common objects, like a bottle of wine. Participants who were thinking about high numbers (e.g. a SSN ending in the 80’s) consistently overestimated the value of the object, whereas those thinking about low numbers (e.g. a SSN ending in the 10’s) underestimated it. The $40 bottle of wine was valued at something like $30 for the low-numbered participants and $50 for the high-numbered participants.
If people anchor onto arbitrary numbers like the last two digits of their SSN, it’s no wonder they anchor onto numbers they find more meaningful. In investing, one of the most common anchors is the original price at which an investor purchased a stock. Bought Apple at $120/share, and now it’s at $100? Many investors would be hesitant to sell until it at least goes back to even. Conversely, at a price of $150, many people would be itching to get out and sell. Such a perspective completely ignores what you should actually base your analysis on – the stock’s intrinsic value – which can change for a variety of factors that may or may not be reflected in the current price. Anchors are useful for ships, but they just drag investors down.
5. Availability Bias
Which is more likely to occur: being in a plane crash, or being struck by lightning?
When asked a question like this, most people say plane crash, but the latter is actually much more likely to occur. What’s going on? The more salient something is in someone’s mind, the more likely he or she thinks it will occur. This probably worked well for our Stone Age ancestors and their instincts 10,000 years ago, but nowadays the frequency we see or hear something is often disconnected from how often it actually occurs. The obvious example is when the media covers events like plane crashes and violent deaths, but not lightning strikes or common traffic accidents. Remember the Malaysian Airlines or Egypt plane crashes? Now, when was the last time you saw a lighting strike on the news?
The availability bias affects the way we invest. Because such stocks are more familiar, investors are more prone to buying stocks of domestic companies than foreign. In addition, people are more likely to purchase stock of their employer and of local companies than other stock.
The problem with this bias is that by focusing on what easily comes to mind, investors are missing out on everything else that doesn’t. An advisor is a useful intermediary when you’re facing availability bias on one end of the spectrum and choice overload on the other.
6. Intertemporal Inconsistency (a.k.a lack of self-control)
I don’t even need to refer to research on this one. Simply put, people procrastinate. We set goals for ourselves, confident that our future selves can meet them, but too often miss the mark. We fail to lose weight, save enough for retirement, or finish a major project on time.
One of the most successful ways to address this issue is to put restraints on our future selves. In the context of finance, one success story is the Save More Tomorrow Program, which a member of our advisory committee, Shlomo Benartzi, helped pioneer. In the program, employees commit a percentage of their future raises to be directed toward their company retirement account. Each time they get a raise, some amount, like 50%, of the increase goes toward their 401k each month. Participants in the program ended up saving much more than their colleagues on a percentage basis over the years. The researchers were fighting fire with fire, using two known behavioral biases – inertia and the power of the default – to combat lack of willpower.
Fight Bias With Bias
These are just six of the more common behavioral biases that may be affecting your finances. As shown in the Save More Tomorrow program, often behavioral science is not only the problem but also part of the solution. The fun part is using biases in a positive way to counteract the ones that are harming you. This is where a neutral third party is often useful to help you both identify your potential biases and develop ways to overcome them.
This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data’s currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money