By now, you’ve probably heard the news: Your own behavioral biases are often the greatest threat to your financial well-being. As investors, we leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done. In fact, Richard Thaler was recently awarded the Nobel Prize in Economics for his work on behavioral economics which has had far reaching implications for public policy.
Why Do We Have Behavioral Biases?
Most of the behavioral biases that influence your investment decisions come from myriad mental shortcuts we depend on to think more efficiently and act more effectively in our busy lives.
Usually (but not always!) these short-cuts work well for us. They can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we’re simply trying to stay afloat in the rushing roar of deliberations and decisions we face every day.
What Do They Do To Us?
As we’ll cover in this series, those same survival-driven instincts that are otherwise so helpful can turn deadly in investing. They overlap with one another, gang up on us, confuse us and contribute to multiple levels of damage done.
Friend or foe, behavioral biases are a formidable force. Even once you know they’re there, you’ll probably still experience them. It’s what your brain does with the chemically induced instincts that fire off in your head long before your higher functions kick in. They trick us into wallowing in what financial author and neurologist William J. Bernstein, MD, PhD, describes as a “Petrie dish of financially pathologic behavior,” including:
- Counterproductive trading – incurring more trading expenses than are necessary, buying when prices are high and selling when they’re low.
- Excessive risk-taking – rejecting the “risk insurance” that global diversification provides, instead over-concentrating in recent winners and abandoning recent losers.
- Favoring emotions over evidence – disregarding decades of evidence-based advice on investment best practices.
What Can We Do About Them?
In this multi-part “ABCs of Behavioral Biases,” we’ll offer an alphabetic introduction to investors’ most damaging behavioral biases, so you can more readily recognize and defend against them the next time they’re happening to you.
Here are a few additional ways you can defend against the behaviorally biased enemy within:
Anchor your investing in a solid plan – By anchoring your trading activities in a carefully constructed plan (with predetermined asset allocations that reflect your personal goals and risk tolerances), you’ll stand a much better chance of overcoming the bias-driven distractions that rock your resolve along the way.
Increase your understanding – Don’t just take our word for it. Here is an entertaining and informative library on the fascinating relationship between your mind and your money:
- “Predictably Irrational,” Dan Ariely
- “Why Smart People Make Big Money Mistakes,” Gary Belsky, Thomas Gilovich
- “Stumbling on Happiness,” Daniel Gilbert
- “Thinking, Fast and Slow,” Daniel Kahneman
- “The Undoing Project,” Michael Lewis
- “Nudge,” Richard Thaler, Cass Sunstein
- “Your Money & Your Brain,” Jason Zweig
Don’t go it alone – Just as you can’t see your face without the benefit of a mirror, your brain has a difficult time “seeing” its own biases. Having an objective advisor well-versed in behavioral finance, dedicated to serving your highest financial interests, and unafraid to show you what you cannot see for yourself is among your strongest defenses against all of the biases we’ll present throughout the rest of this series.
As you learn and explore, we hope you’ll discover: You may be unable to prevent your behavioral biases from staging attacks on your financial resolve. But, forewarned is forearmed. You stand a much better chance of thwarting them once you know they’re there!
In our next piece, we’ll begin our A–Z introduction to many of the most common behavioral biases.