“Investing is overwhelmingly a game of psychology.” – Morgan Housel
As humans, we’re all guilty of biases. Some affect the way we treat others, our religious or political beliefs, and of course, financial decisions. Here we present seven of the more prominent behavioral biases in the investment world.
Recency bias – Investors often buy the hot stock or fund (chase performance) and believe the current market trend (up or down) will continue. In the sports world, you have modest expectations for your team before the season. Then they start the year hot and win several games where they were the underdog. Suddenly, your expectations go way up. New information is weighted more heavily than older data.
Hindsight bias – “I knew it all along” is the classic hindsight bias statement. I would venture to guess more people predicted the February-March stock market sell-off after the fact than before. Past events seem apparent, predictable, and inevitable after they occur, but there’s a reason we say hindsight is 20-20. The future is unknown and unpredictable, end of story.
Anchoring – When Steve Jobs launched the iPad, he said the pundits predicted it would sell for $999. Jobs paused, then announced the actual price: $499. Anchoring represents our tendency to put more emphasis on the first information we encounter. Our brains latch onto the $999 price, and then we’re blown away when we can get the iPad for only $499. Nothing more than a cognitive trick, and you see it all the time. Investors often anchor to the high-water mark of their portfolio value, especially during a correction or bear market.
Confirmation bias – If I believe in X and don’t believe in Y, I will likely search for information that backs up X and refutes Y. Rather than seek out contradictory evidence, humans desire information confirming what they already believe. If you think rabbits are always faster than turtles, you’re probably not a fan of “The Tortoise and the Hare.” “The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.” – F. Scott Fitzgerald
Endowment effect – Car dealerships let you test drive cars for several reasons, most of which are apparent. One reason that isn’t obvious relates to the endowment effect. If a salesperson says they have another customer coming in to look at the car you test drove and like, how does this make you feel? Studies show we value things we own more than those we do not. You might think your house is worth X, while a potential buyer believes it’s worth a lower price. This bias even applies to things we don’t own yet, like the car above.
Herd behavior – Warren Buffett says to “be fearful when others are greedy and greedy only when others are fearful.” Too often, as investors, we do the opposite. The herd’s behavior often changes our perception of reality, causing us to act like lemmings. If you and your neighbor are talking about investments and they say they put all their money in stocks or all their money in cash, this knowledge affects you. Another classic example is the resurgence of day trading since the pandemic began.
Loss aversion – “Roughly speaking, losses hurt about twice as much as gains make you feel good.” – Richard Thaler, author of Misbehaving, and a Nobel Prize winner. Since the pain of investment losses registers in the same part of the brain as physical pain, we seek to avoid losing money. So we don’t sell investments at a loss because admitting defeat is a tough pill to swallow. If your investment loses 10%, it requires an 11% gain to get back to even. If your investment dropped by 50%, you’d need a 100% gain to get back to even. Better to cut your losses and let your winners run.
We began this post with a Morgan Housel quote. After learning more about these seven cognitive biases, we think you’ll agree that “Investing is overwhelmingly a game of psychology.” Thanks for reading.
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