Emotions and psychological influences obviously affect decision-making. Fear, confidence levels, anger and greed are just a few of the very human factors that play a role in not only how individual investment portfolios fare but in how entire markets perform.
Ideally, the decisions made by investors are entirely objective and data-driven. That is rarely the case, however. People are incapable of escaping themselves. Benjamin Graham, the "father of value investing" and author of the seminal works "Security Analysis and the Intelligent Investor," famously declared in the latter (published way back in 1949, mind you) that "the investor's chief problem — and even his worst enemy — is likely to be himself."
The mental roadblocks humans tend to throw in front of their efforts to make sound decisions have come to be known as "cognitive biases." Cognitive biases are so apparent and so inherent that there's no disputing their existence.
Psychological research has identified an array of cognitive biases. Given the foundational level at which these biases exist, they have the capacity to affect practically all decisions, but can have an especially profound impact on financial planning and investment choices. What follows is a look at seven cognitive biases that exert influence over financial decision-making. You likely will recognize each as existing, to one degree or another, within yourself.
Overconfidence bias. Possessing an inflated view of one's own decision-making abilities is a brief way to define overconfidence bias. Affected investors tend to overestimate personal abilities, which can prompt them to make wrong-headed — and ultimately harmful — investment decisions. In fact, one revealing piece of research concluded the most active investors may realize the poorest results precisely because of overconfidence bias.
The study, authored by University of California system professors Terry Odean and Brad Barber, found that, among retail brokerage account owners, the most active investors posted the lowest returns. Odean and Barber suggest, as well, that overconfidence bias is facilitated by a component condition known as self-attribution bias. Individuals with self-attribution bias have a greater tendency to see positive outcomes as functions of their skills and abilities, and negative outcomes as the result of bad luck. Self-attribution bias can block negative internal feedback about low returns, making it more challenging for investors to improve their financial decision-making abilities.
Confirmation bias. Confirmation bias represents another destructive influence on investors. Confirmation bias, as it pertains to portfolio management, prompts one to prioritize information about an investment that agrees with one's existing ideas and beliefs over information that does not so agree.
It is reasonable to assume that investors who adhere to certain investment "schools of thought" or devotees of select asset classes can be particularly prone to confirmation bias. For example, the "gold bug" who insists on investing predominantly in precious metals will often derive validation from select news reports suggesting higher prices for gold in the near term, while dismissing more prominent elements of the investment environment indicating lower prices for gold.
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Whether evaluating specific securities or entire asset classes, investors are best-served by remaining "agnostic" as much as possible. For many people, however, the natural tendency toward confirmation bias can make that a distinct challenge.
Familiarity bias. Familiarity bias is rooted in the idea that people tend to derive greater comfort and confidence from those things with which they're most familiar. It's such a basic behavioral tenet that it really needs no explanation; people maintain closer relationships with those they know best, while keeping strangers at arm's length.
However, while familiarity bias may offer some advantages in the realm of human interaction, it can be problematic for investors. Familiarity bias can prompt individuals to perpetually gravitate toward markets and vehicles well-known to them, at the expense of less-familiar options that may nevertheless be superior. The upshot of familiarity bias is that it can leave investors vulnerable to subpar portfolio returns.
Familiarity bias manifests in a variety of ways, and at a multitude of levels. One example is the 401(k) plan investor who invests only in company stock simply because it's the portfolio option they know the best. Familiarity bias can discourage investors from pursuing viable opportunities in markets, asset classes, sectors, etc., in which they aren't well-versed. As a result, familiarity bias may discourage asset allocation and effective diversification, both of which can help a portfolio minimize risk over the long term.
Endowment effect. Endowment effect refers to the behavior of ascribing greater value to something simply because you already own it. One of the most common examples of endowment effect can be found in the realm of real estate. Agents will tell you that sellers frequently wish to see their properties listed for a sum much higher than that which is suggested by the prevailing market — that's a textbook example of endowment effect. A frequent consequence of endowment effect in that setting is a stale property listing that ultimately expires. When such a houses does eventually sell, it is often for even less than the agent's initial target price.
Endowment effect is evident in securities investing, as well. There, investors have a tendency to evaluate their holdings with a benevolent eye, which frequently encourages them to hang on to a stock or fund long after objective analysis advises selling it. Hence, one of the additional consequences of endowment effect is opportunity cost, which refers to the lost opportunity to put that money to work in an investment with better prospects. Endowment effect, therefore, has the potential to be very destructive to a portfolio's overall performance.
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Loss-aversion bias. People react more strongly to the pain of loss than to the satisfaction of gain. This is the premise of loss aversion bias, which refers to the tendency to make decisions on the basis of avoiding the experience of loss. Loss aversion can emotionally leverage an individual into an unwillingness to accept losses and move on to a more productive alternative.
As you might imagine, investing can be a prominent forum for the expression of loss aversion bias. One of the more common ways loss aversion reveals itself is through an investor unwilling to sell a security that's lost significant value even as other portfolio investments are performing very well. In his book "Common Stocks and Uncommon Profits," Philip Fisher offers a very succinct-yet-compelling summary of the cost of loss aversion:
"This reaction, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process. More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous."
As referenced by the last sentence, opportunity cost is a component consequence of loss aversion bias, as it is with endowment effect and other cognitive biases.
Anchoring bias. Anchoring is another cognitive bias that plagues investors. Anchoring bias involves remaining focused on — or anchored to — a particular piece of information, and evaluating how to proceed exclusively in terms of that information. The fallout of anchoring bias can be similar to that of both loss aversion bias and endowment effect.
A common manifestation of anchoring bias is the investor who cannot bring him- or herself to sell an underperforming stock until the price returns to at least what they paid for it. Let's say Jordan decides to purchase stock of XYZ Co. while it's at $20 per share, and it subsequently drops to $10 per share, with little indication the price will return to $20 anytime soon. Jordan's resistance to selling XYZ until it returns to the price paid for it could be an example of anchoring bias. In this case, Jordan may be anchored to the notion that the stock is worth no less than $20 per share.
"Outside the realm of investing, the effects of cognitive biases can be benign. ... When it comes to investing, however, the effects of these biases can be very impactful."
Anchoring bias can also prompt investors to delay investing in a security or in the market, more generally, until prices go back down to a level they associate with representing an excellent opportunity. The current prices may, in fact, be appropriate, and the security or market may never return to the lower level they desire. But, in this case, anchoring bias drives them to think of the "right" price as being the lower one on which they've fixated.
Investors dealing with anchoring bias risk spending significant time in an ultimately-losing position. Exacerbating that problem is the reality those same investors are missing out on the chance to earn any of that money back — or more — by selling the losing investment and moving the proceeds to another with better prospects; once again, opportunity cost at work.
Herd behavior. Going along with the crowd is another very common human behavior that can affect investment decisions. You've noticed herd behavior at work countless times, even if you did not recognize it as such. For example, how many times have you seen people waiting to go through an airport security checkpoint assemble in one line that's already long, rather than go to a station that has no line?
Part of what makes herd behavior so prevalent is the comfort and implied validation that larger numbers moving in one way or another provides — i.e., "If everyone is doing it, it can't be wrong." This is particularly applicable when it comes to decisions about subjects and circumstances on which one is not an expert. People typically don't have the same level of confidence making decisions about situations with which they're unfamiliar, so herd behavior has the potential to be a stronger influence in those cases.
There are numerous examples of herd behavior as it pertains to investing. The proverbial hot stock or sector is frequently on fire precisely because of herd behavior; an issue that has been a good buy suddenly becomes all the rage on the strength of a favorable groundswell of interest, leading to the one-time value play rapidly becoming another overpriced security.
On a larger scale, this phenomenon can occur with entire markets. The infamous dot-com bubble of the early 2000s was built in no small way on herd behavior. Internet stocks quickly became, for too many, the only place to invest. Huge numbers of people continued pouring money into the sector even as it became well-known the underlying fundamentals of a great many issues were not remotely representative of a sound investment.
It's reasonable to speculate that herding has been a component of investment bubbles and melt-ups through the years. It is also reasonable to speculate that fear of missing out, or FOMO — thought to be a mechanism of bubbles — is itself a component of herd behavior.
The obvious problem with herd behavior for investors is that it's a poor catalyst for investment decisions, just as it can be an imprudent justification for practically any decision.
Counteracting cognitive biases
Outside the realm of investing, the effects of cognitive biases can be benign. After all, there's no real harm done if herd behavior prompts you to gravitate toward a longer line at the airport security checkpoint. When it comes to investing, however, the effects of these biases can be very impactful.
As for how to mitigate cognitive biases, there's no practical, foolproof way for humans to short-circuit their own deeply-rooted behavioral tendencies. That said, being aware of those tendencies are and knowing what to watch for is a good start; heightened awareness of behaviors we'd like to avoid is never a bad thing.
Some have suggested systematic investing strategies, such as dollar-cost averaging, as a way to deal with behavior biases. From a bias-mitigation standpoint, however, dollar-cost averaging is limited in its utility. While the practice helps to ensure regular investing and may lower both risk and cost basis, you must still decide which security will receive the money. Nothing about the dollar-cost averaging protocol circumvents whatever biases may have influenced the selection of that security in the first place.
Another option to help limit the effects of cognitive biases is relying on the services of a money manager. While investment professionals can certainly be susceptible to biases, there are two potential advantages offered to investors who go this route. For one thing, it's not unreasonable to expect advisors to possess a greater ability — in comparison to "average" people — to evaluate a portfolio on the basis of objective analysis. For another, because the money they're managing is not their own, whatever biases financial advisors are at risk of deferring to may be less compelling.
The importance of remaining aware of cognitive biases and working to repel their influence cannot be overstated. With the interest rate climate expected to become increasingly adverse for the stock market, investors shouldn't expect to see the same generous returns they've enjoyed for the last several years.
Some investment strategists are predicting the onset of a "lost decade" in the stock market, where only more active investors stand a chance of earning competitive returns.
Should such an era in equities occur, one in which markets will be less forgiving of mistakes and inattention, the ability to limit any shortcomings in their decision-making processes can improve outcomes for investors.
