Sam's Corner: Mind the (Behavioral) Gap

Odds are we have all been in situations where you question, what the heck is this person thinking? The choices others make can strike us as incredibly irrational. In cases such as this, it is easy to identify the right choice when observing others, however judgement becomes clouded when it us making decisions. We are all different in our approach to decision-making. Our predispositions potentially skew our thinking to less-than-ideal choices. This can be problematic in our daily lives, but also rears its head in our long-term investment decisions.

Traditional thinking treats the broad market and individuals as universally rational actors. These assumptions are the foundation upon which the Efficient Market Hypothesis (a future topic we will cover) was created. Famous economist and Nobel laureate Eugene Fama from the University of Chicago popularized this hypothesis. However, the EMH has been challenged by a group of rogue economists led notably by the late Daniel Kahneman and Richard Thaler. This clique is known under the banner of behavioral economists. The new field of behavioral finance blends psychology and traditional economics, illustrating that cognitive and emotional biases can impair investor behavior.

Through a near endless list of studies, researchers have successfully identified prominent biases that investors are prone to, causing suboptimal investment outcomes. A few of these common biases we at the Paradigm Group work with clients to identify and overcome are:

- Loss Aversion – it sucks to lose money. So much so that people prefer to avoid losses over making the same number of gains. Losing $500 is much more painful than winning that same $500. This affects individuals and professional investors alike. We can find ourselves ignoring investment opportunities’ out of fear that markets move the wrong way against us. This thinking can create analysis paralysis and may cause individuals to hoard mountains of cash under their mattresses or opt for risk-free assets instead of focusing on long-term growth objectives to meet financial goals. One way to overcome this bias is to set specific, identifiable targets to buy or sell an investment. Focusing on that goal introduces discipline to get off the sidelines and encourage participation in the market.

- The Endowment Effect – people typically value an object higher if they already own it. This trait, known as the endowment effect, can lead to holding on to a free coffee mug or ratty old college sweatshirt. This is harmless enough, but also influences larger decision making such as an owner overvaluing the sale price of companies they founded. The endowment effect is often found with inherited investment assets. For good reason we place sentimental value on inherited stock positions. If it was good enough for mom or dad, it should do the job for us. However, risk characteristics and financial goals for individuals are vastly different. What is an appropriate stock holding for one person may not be for another – sentimentality may cloud our judgement in the appropriateness of holding onto an asset passed between generations.

- Overconfidence – 73% of drivers think they are better than average. People tend to overestimate their abilities beyond just their driving skills. Despite what I tell my coworkers, friends or anyone who will listen, and this is painful to admit… I am not the next Warren Buffet. Like driving, or my delusions of grandeur, investors fall prey to overestimating that they are smarter or more well informed than the average participant in the market. This bias affects individual investors and professional money managers alike. In fact, it can be more acutely felt by professional fund managers with 74% thinking they are above average. They are probably the same folks who think they are good drivers! The more confident we are, the costlier mistakes can be.

- Confirmation Bias – has anyone noticed that politics are polarizing? We all know folks who get their news from a single source, rejecting all other information. Why is this the case? It is comforting to reinforce our existing beliefs. Challenging any sort of strongly engrained idea can be treated as an attack on how we view the world. Confirmation bias is easily identifiable in the political realm but found constantly in investment markets. If I am all-in on a single equity, odds are I want to read good news about it and disregard troubling reports. It is similarly difficult to be malleable in our investment thinking to process information that may cut against our beliefs for owning an asset.

With the field of behavioral finance being relatively new, it makes it an exciting time to follow along as new biases are being uncovered. The majority of rockstar researchers in this space are alive, and publishing. Their findings challenge long held tenets in the traditional investment community. We all want what is best for ourselves, families, and communities, but may not act in the best manner to achieve our goals. While it is impossible to be an entirely unemotional and logical, we can take steps to confronting bad behavior patterns in our investing.

One way to counteract these behavioral biases is to consult an external party – ala a financial advisor (and their humble employees who find behavioral research interesting). Working with an advisor can help avoid pitfalls in asset allocation decisions and identify potential blind spots that may have negative implications for our long-term financial plans.

For those who may be interested in further reading, here are a few very accessible book recommendations on the topic:

-  Misbehaving – Richard Thaler

- Thinking Fast and Slow – Daniel Kahneman

- The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness – Morgan Housel

- Irrational Exuberance – Robert Shiller