In the late 1960s, spearheaded by the groundbreaking work of Nobel Prize-winning psychologist Daniel Kahneman, the academic field of behavioral finance took root. The fundamental premise was simple: to develop a better understanding of the behavioral tendencies and biases that drive us to make poor decisions about money, finances and investing. Over the subsequent decades, a number of renowned psychologists and economists have joined forces to build upon this foundation and help paint a much clearer picture of why we all too often do precisely the wrong things at the wrong time.
In the 20-year time span since 1996, despite extended periods of market turbulence and high volatility the S&P 500 Index® has averaged an 8.2 percent annual return. During that same period, the average investor has managed to earn just 2.1 percent annually on their portfolio.1 How do those differing rates of return translate into real dollars? A hypothetical $1 million portfolio invested to perfectly track the S&P 500 would be worth nearly five times more today ($4.8 million) than 20 years ago, yet the average investor’s portfolio has barely grown by half ($1.5 million) its original value.
While fees and expenses account for a small fraction of the difference, the vast majority of underperformance can be directly traced to the powerful psychological biases that influence our decision-making processes and may lead us to actions that are inconsistent to our normal behavior when it comes to our investments. By recognizing and understanding these common behavioral biases, you will be better able to gauge how they may be adversely influencing your decisions. “Biases aren’t inherently bad,” explains Joe Sicchitano, Senior Vice President and Head of Financial Planning for SunTrust Private Wealth Management. “But it’s vital to understand those biases and how they impact your decision-making so you don’t allow a single emotion-based moment undo years of thoughtful planning.”
Our own worst enemy: 8 biases you should strive to avoid
We often think and act in counter-productive but predictable ways—often basing our decisions on feelings and instincts rather than evidence and facts. Many of these behaviors seem almost hard-wired into our earliest human DNA: from a time when following the herd and avoiding the unknown could make the difference between life and death. In the investment world, however, our innate biases often act as deterrents to success and anchors that slow our progress on the path to financial confidence. Although by no means a comprehensive list, the following are some of the most prevalent biases:
Status quo bias – instinctively, we are creatures of habit who prefer the relative comfort of the familiar compared to the unknown. It’s the reason so many struggle with procrastination and inertia, putting off important decision (even those they know are in the best interest) until sometime in the future. Status quo bias is what prevents us from putting aside an extra few percent into our 401(k) because we’ve become accustomed to our take-home pay. And it’s one of the key impediments that cause us to hold onto investments even when doing so is contrary to our best interests.
Loss aversion – in all aspects of life, people tend to experience the pain associated with loss far more intensely than the pleasure associated with gain. It’s a bias that translates across all facets of our lives, perhaps nowhere as clearly as our finances. Loss aversion is the driving force that will cause us to spend hours turning our house upside down in anguish over a $20 bill we misplaced, compared to the moment of euphoria we experience when we find a $20 bill as we walk down the street. As a result, people tend to err on the side of caution, being far too risk-averse with their portfolio and avoiding potentially beneficial long-term investments because of the potential for short-term losses. It also explains why despite the potential tax disadvantages, equity investors tend to sell their “winners” while holding on to their “losers.”
Present bias – psychological studies show that most people place a significantly greater value on something they receive now compared to the same thing (or in many cases even something more valuable) received in the future. Also called “hyperbolic discounting,” it’s a principal that not only explains why so many people put off saving for the future, but also why we’re inclined to take on more future debt than we should in order to finance current needs.
Recency/availability bias – faced with making a decision, our tendency is to give more credence to recent events and widely disseminated information than we do to longer-term trends. This is especially true when that information or event is/was emotionally impactful. In 2010, with the memory of the market’s 37 percent drop during the 2008 economic crisis still fresh on people’s minds, Franklin Templeton surveyed investors to gauge their impression as to whether the market was down, flat, or up for 2009. Despite the fact that the market has risen 26.5 percent, two-thirds of investors indicated that the market was either down or flat. It’s the same principal that leads investors to react to the immediate: fleeing the market after a steep drop and missing out on the recovery, or jumping into the market after a long run-up.
Confirmation bias – you develop a strong, positive feeling about a certain stock or market sector and begin to research it. In researching the idea, however, most people tend to subconsciously seek out information that confirms the original belief while ignoring any information that runs counter to the belief. Our confirmation bias causes all the green flags to flash brightly while all the red flags fade into the background.
Clue-seeking bias – why do we subconsciously look for patterns and clues in seemingly random and chance events? Whether it’s the roulette player who bets black after seeing red come up four times in a row, or the 401(k) investor who chooses the first mutual fund on a provided list assuming it must be preferred because it is listed first, we often use irrational reasoning in trying to make rational decisions.
Optimism/overconfidence bias – ask a room full of 100 adults to rate themselves as either a below-average, average or above-average driver. Chances are that upwards of 90 percent will categorize themselves as either average or above average. We inevitably estimate higher than average odds of good things happening to us while we estimate lower than average odds of bad things happening. And it’s one of the chief reasons why financial planners often struggle to convince clients to have contingency plans in place for long-term care needs and other potential negative events.
Herding bias – whether it’s watching the latest “must-see tv” or buying the newest cutting-edge technology, we are social animals that tend to follow the herd, even when the herd may be acting counter to our own best interests. It’s one of the key reasons why so many investors end up buying high and selling low, and why the rare ability and willingness to stand alone and move counter to the prevailing wisdom sets investors like Warren Buffett apart from the crowd.
Strategies for overcoming your biases
By merely recognizing and admitting your inherent biases you can make tremendous strides in beginning to overcome them. It’s important to understand, however, that although self-awareness can improve your financial outcomes, it will not eradicate your biases so constant vigilance is paramount.
Make a conscious effort to gather empirical data that will help to balance intuition and instinct, and actively seek out any and all evidence that stands counter to your basic assumptions. Learn from both your failures and your successes so you can avoid the former and replicate the latter in the future. And at all costs avoid information overload. Between CNBC, social media and 24/7 access to a world of financial data, it’s easy to get either overwhelmed or overconfident. When it comes to investing, there are simply no sure things and any effort to predict short-term market movements is nothing more than a fool’s errand.
“People who are right most of the time are people who change their minds often.”—Jeff Bezos, founder and CEO of Amazon.com
Most importantly, rely on your SunTrust advisor to help you establish a comprehensive financial plan to address both your short- and long-term goals. Let that plan act as your roadmap from uncertainty to confidence, continually monitoring and adjusting it as your needs and circumstances dictate, rather than making changes to your investments as a result of market movements. Working with an advisor can serve as an invaluable sounding board, providing alternative ideas and pointing out situations where your personal biases may be working counter to your long-term best interests.
Thoughtful, strategic investing is a marathon, not a sprint. This can be especially challenging since the most prudent investment decisions may not always yield the most impressive short-term results. But by better knowing yourself and your particular biases, you should be far more disciplined in focusing on the long-term and far less likely to stumble along the way.