- Memory Bias Or: Forget That Historical Noise! It's Different Now
- Not Accounting For Sample Size Or: I’m Sure It’s Always Been Like This
- Overconfidence Or: Indexing Is For People Who Can’t Do It On Their Own
- Conservatism/Confirmation Bias Or: This Fact Backs Me Up So I'll Ignore That One That Doesn’t
- Framing Or: It’s Better To Look At What You Could Gain Instead Of What You Could Lose
- Mental Accounting Or: I Don’t Want To Lose The Kid’s College Fund!
- Regret Avoidance Or: It Has To Come Back Up Some Time, Right?
- Affect Bias Or: I Really Like Their Mission
- What Does It All Mean?
As humans, we don’t always make the most rational decisions. Sometimes other things trump rational thought. Avoid these common investor behavioral mistakes.
Behavioral finance acknowledges that you and I aren’t the perfectly rational, logical, and well informed beings that traditional finance assumes us to be. We take tips from friends, hate losing a dollar more than winning one, don’t instantly hear and internalize new information, and we’re all above average (when self-reporting, at least).
With that in mind, here are some behaviors to watch out for in your investing though they’re commonly seen outside of investing as well. I’m guilty of them and you may be too!
Memory Bias Or: Forget That Historical Noise! It’s Different Now
Your recent experiences weigh more heavily in your planning and decision making than your past experiences. How many people do you know who pulled their money out of the stock market in 2009 because it had tanked in late 2008 and early 2009?
Unfortunately for them they missed out on the subsequent 50% rebound of the rest of the year, assuming they pulled out at rock bottom. These may have been folks with solid investing plans who were aware that the market historically returned between 7-11% but still couldn’t see past that 50% drop.
Similarly, people are surprised that the companies who tend to do well one year, do poorly the next, and vice versa. As Investopedia points out however, this makes sense. If a stock did really well one year, it may have set high expectations and a big price tag. To match that, it would have to outperform its previous outperformance, which is difficult.
Not Accounting For Sample Size Or: I’m Sure It’s Always Been Like This
This is related to recency bias and basically means you need to look at broad trends and not get too hyped up over small trends. If you started investing in 2008 you probably thought that all stocks sucked and going in to the market is for fools. If you were smart (read: lucky) enough to jump in right after the bottom in 2009, you probably think the market is the greatest thing ever because you’ve tripled your investment.
Overconfidence Or: Indexing Is For People Who Can’t Do It On Their Own
You know you’re the shit and you’ve got this investing thing nailed! You bought Tesla at $100 and were mining Bitcoins in 2011. It’s the same reason you’re better than the average driver! People should just give you their money to invest.
Not only are you ignoring sample size, (two good picks does not make you Warren Buffett) you’re claiming you buck the trend that index based investing over a long time frame with minimal tinkering is the best strategy for the vast majority of people.
I’m too cheap to license it, so please click the link to enjoy this Dilbert comic that sums it up perfectly. As a final note, people who trade a lot and men most frequently make this mistake.
Conservatism/Confirmation Bias Or: This Fact Backs Me Up So I’ll Ignore That One That Doesn’t
You are too slow to change your beliefs to match new evidence and primarily look for evidence that supports your what you already believe. Personally, if I were to learn that Google’s search engine was powered by baby tears, (it isn’t) it would still take me a while to toss their stock.
I admire the company and have done well with the stock, not to mention they’re on my list of companies I really wish I had bought years ago. Some of my friends work there and casually mention perks I wish I had. Given their slogan of “Don’t be evil,” news like that would likely kill their stock and I’d take some serious losses because I wouldn’t react quickly enough.
Framing Or: It’s Better To Look At What You Could Gain Instead Of What You Could Lose
We suck at answering the same question consistently when the questioner changes the framing on us. Below are results from a study on the phenomenon:
Participants were asked to choose between two treatments for 600 people affected by a deadly disease. Treatment A was predicted to result in 400 deaths, whereas treatment B had a 33% chance that no one would die but a 66% chance that everyone would die. This choice was then presented to participants either with positive framing, i.e. how many people would live, or with negative framing, i.e. how many people would die.
Treatment A was chosen by 72% of participants when it was presented with positive framing (“saves 200 lives”) dropping to only 22% when the same choice was presented with negative framing (“400 people will die”).
Mental Accounting Or: I Don’t Want To Lose The Kid’s College Fund!
Mental accounting is a subset of framing. This is when you separate your decisions based on the purpose of the investment as opposed to looking at your overall picture. Essentially, do you have investments for education that are allocated differently than your general portfolio that has the same time frame?
If you are assuming two investments have the same time frame and from there determine how you’re going to invest, it shouldn’t matter what purpose you plan to use the money for.
Another aspect of this is the house money effect, or taking more or bigger bets once you’re up. I certainly fall in to this trap in my poker games. Once I’m not risking my money, what’s the harm in losing the house money?
It does make sense to do some mental accounting when you have different time frames (money to buy a house in 2 years vs retiring in 30) or purposes (oh shit fund vs vacation fund).
Regret Avoidance Or: It Has To Come Back Up Some Time, Right?
Losing sucks. It especially sucks when you made a call that ended up being wrong and you lost because of it and is even worse when it was a risky decision with potential for high rewards.
This happens all of the time in investing because no one knows exactly what’s going to happen next. If they did, you’d know their name because they would own everything. However, it’s often better to bite the bullet and leave a sinking ship than to go down with it because you don’t want to admit to having made a wrong call.
What I try to do is offset my regret at having made a terrible call (of course weed companies will do well in Colorado!) by enjoying the fact that those losses will mean some sweet, sweet tax reductions in the future.
Affect Bias Or: I Really Like Their Mission
Companies that do things that make you feel good inside or wish you worked there, (Google, from my previous example) tend to do better than companies that feel like they’re part of an evil corporate empire. In my case the company that would have been a good choice to have in my portfolio but I avoided, was Exxon.
I felt that I couldn’t buy their stock because I studied environmental science and feel like I understand a lot of the issues caused by oil drilling and consumption. Up until this point, it turned out I made a good call because oil slumped but if we ignore the small sample size (2 years) and my strong bias against an energy producer, it could have been a solid part of my portfolio, historically.
In this case, I feel as though it comes down to making a conscious decision. I didn’t buy energy companies knowing that I would likely take a hit to my portfolio but often these kinds of thoughts creep in unconsciously and you need to be careful of them.
What Does It All Mean?
It means that while you’re not a perfectly logical machine that’s custom built for investing, you can improve your performance by trying to be aware of common biases and mistakes. Most of these won’t make or break your investing unless you decide to go the ever popular route of buy high and sell low. Think, be conscious of what’s going into your decisions, and you will be fine.
Featured Image Photo Credit: “Head in Hands” by Alex Promios on Flickr