FINANCIAL LITERACY • READ TIME: 5 MIN
"Traditional economics is based on imaginary creatures sometimes referred to as 'Homo economicus.' I call them Econs for short.
Econs are amazingly smart and are free of emotion, distraction, or self-control problems. Think Mr. Spock from 'Star Trek.'"
Richard Thaler
Adding a Human Element to Financial Theory
In juxtaposition to most economic models and theories, behavioral finance assumes market participants are not perfectly rational or self-controlled. In fact, behavioral finance posits investors’ mental states, biases, and past experiences interfere with rational decision-making skills.
Broadly, behavioral finance is the field of study that incorporates the impact of psychological influences on the realm of finance - on both markets and individual investors. A key element of behavioral finance is the analysis of psychological biases which may negatively impact financial decision-making. In short, behavioral finance seeks to understand what makes otherwise rational individuals become irrational investors.
Identifying and Defining Five Common Biases
Below are five common cognitive biases that may be present in your financial thinking and/or decision-making process. Although the intent is not to live and act as "Econs," as Richard Thaler calls them, the goal is to eliminate potential sources of error in the process involved in financial decision-making in regard to developing and implementing financial plans/investment portfolios, and in every day spending or saving.
(1) Anchoring
Anchoring refers to an arbitrary benchmark - such as a purchase price or high-water mark - assigned to a security, portfolio, etc. by an investor. Specifically related to loss in value of a security or portfolio, this bias can cause investors to hold on to an investment (or group of investments) with the hope of “getting back to even.” In short, anchoring is the irrational assignment of significance to a particular value.
The values, known as “anchors,” are unrelated to how securities are priced. Meaning, the "arbitrariness" of a particular price is not grounded in any kind of fundamental valuation model. Additionally, the arbitrary values assigned may cause investors to reject rational decisions - refusing to sell securities at a loss, for example, in order to rebalance or reposition a portfolio.
(2) Loss Aversion
Loss aversion is a bias that describes why loss feels worse than the goodness felt from gain. In fact, Amos Tversky and Daniel Kahneman (the psychologists who studied and identified this phenomenon) posit that the pain of loss is twice as great as the pleasure of gaining. Loss aversion, therefore, refers to an investor’s inclination to avoid loss as opposed to achieving equivalent gains.
The psychology of loss is believed to be one contributor to the asymmetry of volatility exhibited in stock markets wherein market volatility is much higher in declining markets than in rising markets. If you are familiar with the term “panic selling,” then loss aversion may be one underlying explanation.
Loss aversion is present in all aspects of life, not just in financial markets. However, in relation to the stock market, loss aversion may give way to a significant “negativity bias” - meaning, all news and information is filtered through a pessimistic lens. This, in turn, may cause an investor to miss a bull run or recovery period during/after a market correction.
(3) Outcome Bias
Outcome bias describes the way in which individuals tend to focus only on an end result without consideration for the process leading up to the conclusion. Put another way, consider the following example:
“Investor A invested in a particular stock five years ago and has generated a significant return on the original investment. After speaking with Investor A and hearing of the success with this stock, Investor B decides to purchase the same stock. Investor B, however, never generates a gain with this security."
Investor B only considered Investor A’s outcome - not the process that led to an outsized return. In the five years since investor A’s investment, a number of factors may have changed which were the original source of Investor A’s success: the state of the overall economy or the strength of the company’s financials (earnings, etc.), for example.
Outcome bias reveals our tendency to measure events solely on their result, rather than the rationale, process, etc. that helped us (or others) arrive at a particular conclusion.
(4) Recency Bias
Recency bias, also known as availability bias, describes the psychological phenomenon wherein investors place greater weight on recent information or events with little regard for the long-term probability of said event continuing. For example, recent news or events may cause investors to sell during bear markets ("markets in turmoil!") or buy into bubbles (with headlines such as "The Hottest Stocks You Need in Your Portfolio") because these events are “in the headlines.”
More often than not, drawdowns are just corrections. Although each correction may feel more severe than corrections in the past, they are a normal part of the cycle investing. The same is true on the other side: in bull markets and/or bubbles, securities tend to revert to fundamental valuations methods (price-to-earnings, yield, dividend growth, etc.) in the long run.
(5) Mental Accounting
Mental account is the cognitive bias wherein individuals assign subjective values or categorizations ("bucketing") to money depending on factors such as how the money was earned or how the money will be used. Essentially, mental accounting violates the inherent fungibility of money.
For example, assume an investor has earmarked funds in a savings account for a vacation. Before booking flights and hotels and other vacation-related items, the investor’s water heater breaks and they must purchase a new one. Instead of paying for the water heater from the savings account, the investor takes a 401(k) loan.
Rather than “dipping into” the vacation fund, the client takes money from an inopportune place to pay for the water heater. This is how mental accounting can cloud otherwise rational judgment - it violates the maxim, “a dollar is a dollar is a dollar.”
Building Awareness to Overcome Cognitive Biases
All decisions, whether or not they are financial, are typically influenced by emotion, experiences, and/or some form of bias. Understanding the cognitive biases at play in financial decision-making is one step in overcoming them. Being aware of, as well as avoiding, cognitive biases is a way to sidestep potential financial errors.
For most investors, a sound way to overcome cognitive biases is to work with a financial professional to create a financial plan and/or investment policy statement that incorporates risk tolerance, time horizon, liquidity needs, and other relevant constraints. And then, ultimately, to "stick to the plan" in times of (typically, short-term) market volatility. This guidance can help an investor "separate the signal from the noise." Updates to the financial plan, etc. can and should be made on an as-needed basis when there are significant changes in circumstances, financial goals, or other relevant elements.
Oftentimes, the advice of "sticking to the plan" is easier said and agreed upon than done. For most investors, the impulse to take action - particularly during turbulent markets - is quite strong. However, pairing a financial plan with financial advice from a professional can help weather market volatility, counteract natural biases, and ensure your financial plan is tailored to your particular situation.
To talk to our team about developing or updating your financial plan, as well as ensuring your portfolio is in line with your financial circumstances, set up a call or meeting with RP Wealth Advisors to learn how we can help.
The content is developed from sources believed to be providing accurate information. All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy referenced here will be successful. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by RP Wealth Advisors to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.