Behavioral finance studies the biases that impede our ability to make rational economic decisions. By at least being aware these exist, maybe we can help you (and ourselves) limit the potential damage they can inflict. Here are seven of the most common biases.
Recency bias – Recent information is weighed more heavily than older information. In the investing world, this often manifests itself in chasing performance, buying the hot stock or mutual fund and expecting the recent history to continue into the future.
Hindsight bias – It’s very easy to predict the past. The future is another story. Our tendency to believe a past event was not only obvious but predictable is referred to as hindsight bias. Only with 20-20 hindsight are past events obvious.
Anchoring – This represents our tendency to focus too much weight on the first piece of information we encounter when making a decision. If you’re shopping for a used car, the sticker price serves as the “anchor.” All subsequent negotiations go off this original price, regardless of its accuracy. Another example…You’re shopping for a new leather jacket and find one you love and must have. You check the price tag: $1,000. Just then a store clerk walks up and says the same jacket is on sale for $450. Seems like a relative bargain, right? Nope, just anchoring.
Confirmation bias – This is a tendency to look for facts that support your position while ignoring those that don’t. Investors who own ABC Company stock may ignore negative developments because they have a vested interest in the stock doing well. Perhaps company fundamentals are the reason the stock has gone from $75 to $25. But you’re too glued to the few snippets of positive news coming out about the company, which confirms your bias.
Endowment effect – Investors often believe they know more about a company whose headquarters are in their city or state, and thus they tend to place a larger premium on these shares. In English, this means we are willing to pay more to buy a company that is physically closer to us than one farther away because we think we know it better than we actually do.
Herd behavior – Warren Buffett says to “be fearful when others are greedy and greedy only when others are fearful.” Too often, we do the opposite. The behavior of the herd often changes our perception of reality, causing us to go along with them to our detriment. The tech bubble of the late 1990s and the real estate bubble of the 2000s are just the most recent examples of herd behavior.
Loss aversion – Losses register in the same part of the brain as physical pain, thus making it oh so difficult to sell that losing position, admit defeat, and go on to the next investment. We tend to hold onto losing investments in the hope they will rebound, we’ll recoup our loss, and save face. Limit your losses and go on to the next trade.
So there are seven of the most common behavioral biases as they relate to investing and money. How many did you recognize?