When it comes to making money decisions, humans are not always logical. We have a tendency to make behavioral mistakes and let emotions get in the way. Whether it’s being overcome by fear or greed, or letting the recency effect or confirmation bias cloud our judgment, these and other biases can hurt our investment returns.
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Do you remember back in the late 1990s when the stock market was soaring and technology stocks reached astronomical valuations? Or how about the mid-2000s when real estate prices soared and people were making money flipping houses? Those are just a couple examples of how emotions and psychology led people to bid up prices way beyond a reasonable value.
In recent years, a new field of study called “behavioral finance” has arisen to study how psychology plays an important role in how we make investment decisions. In an ideal world, we would all make calm, cool, rational decisions about our money. But in reality, our “humanness” sometimes gets the best of us and we make behavioral mistakes.
The best investors are not only good at math, they also understand the “psychology” of investing and are able to manage the emotions and biases that affect all of us.
In today’s episode, we talk about several common behavioral biases and discuss how you can overcome them. It’s an important conversation that could help you avoid making behavioral mistakes in the heat of the moment.
Five Quotes From Bill Keen in This Episode
- What happened recently may not continue. One of the first biases that we see is the recency bias. The recency bias means that what’s recently happened, we tend to think, will continue to happen in the future and not only in the future but possibly forever. For example, if the stock market is in a downtrend, we may think it will continue to go down. However, the way we should look at it is more like a rubber-band. When things get stretched in one direction, it’s just building up some power or energy and it may snap back in the other direction at some point. Things often revert to the mean over time.
- We tend to hang around people and seek sources that agree with our opinions. Confirmation bias is our tendency to search for or interpret information that confirms what we already believe. We shut out dissenting information or opinions because they don’t agree with what we already believe. A simple example is politics. People often listen to TV stations or follow politicians that match their beliefs. If you’re a Republican, you’re probably watching the Republican debates and not watching Democratic debates, and vice-versa. To overcome this bias in investing, we get data and objectively look at it. We buy research from people that don’t agree with me and don’t agree with each other from a fundamental and technical standpoint. I believe it’s good to have people arguing and looking at all the points and then we can step back, look at the data, and come up with what we believe is an appropriate observation.
- Everybody loves a good story but investment stories can hurt you. In order to make sense of a complicated investment world, investors often look at a string of facts then try to create a “narrative” or story to fit the facts. We try to explain the facts by turning them into a story as if the facts were all related and part of a sequence. While some of the greatest teachers are people who can take complicated concepts and make them simple and understandable, we have to be careful. As investors, we have to be sure we look at the data from as objective an angle as we can so we don’t get mesmerized and “taken in” by a great story that may not fit reality.
- We treat money differently that we didn’t have to work for. If you’ve ever been to Las Vegas and won money, you may have started to take bigger risks because you were playing with “house money.” The fact is, money’s money whether you won it, found it, or made it through investing. You should treat money the same regardless of the source. From a practical standpoint, this can come into play when a client’s portfolio is doing extremely well and they are ahead of plan. Sometimes there’s a feeling that this extra money can be handled more aggressively or spent for some splurge item. In reality, the good years in the market help us build up reserves to offset the down years and over time, the good and bad years tend to average themselves out.
- We feel more pain from a loss than we get pleasure from an equivalent gain. People hate to lose. In fact, we often go to great lengths to avoid losing. And when it comes to money, researchers have discovered that we feel about twice as much pain from a loss as we feel pleasure from an equivalent gain. This concept of “loss aversion” may cause investors to make less than optimal investing decisions. One way to help overcome this bias is to reframe the situation from a negative frame of loss to a positive frame of gain. If trying to avoid or recognize a loss is causing you to make a potentially bad decision, try looking at the situation from what you could gain by making the decision. Also, if you have a long-term plan in place and you realize that you have to go through a little bit of short-term discomfort to obtain a long-term dignified life and you can see it and it’s planned for and it’s real, you’re way less likely to make behavioral mistakes like this.
Bill Keen on biases…
What we’ve done today is brought light to some of these behavioral biases that are pretty common and if it can help our listeners to avoid or at least get conscious of them when they come up, I think we’ve been successful.
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