Behavioral finance is the study of how people make financial decisions. We are all affected by different biases that impact our decision-making on a daily basis. It’s important to examine and raise awareness of a bias or biases we are all susceptible to, so that we can overcome them, especially in market environments like we have recently experienced. Below are a few of the more common biases.
Studies have shown that when we have an initial belief, we tend to seek out opinions and articles that reinforce that belief, which is referred to as the confirmation bias. Regardless of perspective, we are likely to be attracted to sources that reinforce our opinions. This decision-making process is especially relevant in today’s digital society, where we can shop for the best view that matches up to our view all over social media. Is this bad? Confirmation bias can be rather dangerous because it may cause us to ignore all of the relevant information and also lead to overconfidence in our decisions.
Our favorite way to explain loss aversion is with the Paul Samuelson proposition, a Nobel prize-winning economist. If Paul was having lunch with somebody, he would offer them this proposition, “Hey, let’s flip a coin. If I win the coin toss, you pay me $100. But if you win, I’ll pay you $200.” Statistically, most economists would say that’s a good bet to take, yet Samuelson’s colleagues would not take the bet because they put more value on avoiding the $100 lost, rather than the potential for a $200 gain.
We can see this manifest itself in the market too. During this and past crises we generally see a rise in the amount of cash that moves into Money Market funds. Why is this happening? The average investor is looking to avoid losses they are experiencing in a market downturn, and their instinct is to go to cash to avoid those losses. Our brains feel the pain of the loss roughly twice as much as we do the joy of the gain, which can cause investors to become more conservative at exactly the wrong time.
Home Country Bias or Availability Bias
We like things that are familiar to us, and so our home country bias would be that because the US is familiar to us, we’re going to invest the majority of our assets here. We have even seen this with investment managers located on the West Coast and East Coast – their portfolios tend to be overweight to those companies geographically close to them.
This bias can cause us to become too concentrated in any one country and cause us to be less diversified, which can add more risk to the portfolio over the long-term.
A great example of recency bias is what we saw back in 2008 and 2009. In 2008, the market was down 37%. The market bottomed in March of 2009 and that calendar year ended up being really great — up 26.5%. Interestingly, in an investor sentiment survey done in 2010, two out of three investors actually thought that the market was down or flat in 2009, despite being up 26.5%. How could this be? The majority of investors did not feel good about what was going on in the economy at that time. The market is a leading indicator of the economy, so using our recent feelings about the markets or economy to make investment decisions often leads to wrong decisions.
We want to overcome our behavioral biases in order to reach better-informed decisions in our financial life. This is one of the roles our Wealth Advisors at RegentAtlantic serve with our clients— to identify and point out biases that someone might be exhibiting as they are making financial or investment decisions. This is especially important when we go through any type of painful experience, such as the current pandemic and subsequent market decline.
Another way we can overcome biases to is to focus on our long-term goals and plans, such as travel, second homes or funding retirement living expenses. If we can maintain focus on these longer-term goals, it allows us to make sound decisions about our financial future and ensure we do not make rash decisions based on current conditions without considering their long-term impact.
Eliminating the Noise
This refers back to the confirmation bias highlighted at the beginning of this article. The COVID-19 Pandemic is an event that we have not witnessed during our modern economy. There are a lot of polarizing views on what the short-term and long-term impacts may be, and those views are changing frequently. It’s easy for us to seek out those views that align with our own, and doing so convinces us that we are absolutely going to be right. Eliminating some of the media noise can help us refrain from a confirmation bias and become overconfident in our decisions. As an advisor and a fiduciary, our role is to provide objective, balanced advice that eliminates the noise and is always in the client’s best interest.
Click here to view our Behavioral Biases in the Road to Economic Recovery webinar recording.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.
This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.