I admit it, I was glued to the Kavanaugh hearings on September 27th. I wanted to hear the respective stories told fully from each party rather than how the media was going to interpret them for me. Why are we all so fascinated by this process? Yes, it is a very important decision regarding our nation’s Supreme Court. But, I think it has everything to do with the emotions involved. I can see both sides—being a woman in a male-dominated industry with a daughter, as well as a mother to an athletic male attending a private school.
Whatever side you sit on, the emotions are powerful. Emotions captivate us in all areas of our lives. Most often in ways we cannot recognize. We may not even realize what emotions are driving us to do, even when we are dealing with a seemingly research-based investment industry. As an investment professional, it is my job to understand the facts behind investing and get beyond these emotional tendencies. Additionally, I am here to educate and guide clients around these emotions when the factual inputs are not as well known to them.
Behavioral finance has been discussed for many years. Daniel Kahneman and Amos Tversky, the fathers of behavioral finance, began collaborating on the subject in the 1960s. Richard Thaler brought the ideas to the mainstream industry when he helped combine psychological theory with economics and finance. Thaler received the Economics Nobel Prize for his work in this area.
It is important for all investors to be aware of ways emotions and/or behaviors can affect investment decisions. These decisions not only impact what investments are chosen, but also the way we save for our financial future and may even impact careers in ways we’ve never considered.
U.S. News & World Report published an article in 2015 that outlines what I think is a succinct, comprehensive list of behavioral biases that may hurt your investments. I think they are worth repeating.
1. Loss Aversion. People often feel the pain of loss more than the joy of gains. The memory of past losses can cause us to make decisions to avoid loss rather than exploit opportunities for gain.
2. Confirmation Bias. People are often drawn to information or ideas that validate existing beliefs or opinions. This may lead us to investments that are most comfortable to us, like investing in the company we work for rather than seeking diversification and opening up to other opportunities.
3. Mental Accounting. A person views various sources of money as being different from others. For example, money earned from a job may be viewed differently than inherited money. Or, different investments may be viewed differently. Stocks that are inherited may be viewed differently from investments in your 401k. This may lead investors to keep stocks that are not necessarily healthy for their portfolio.
4. Illusion of Control Bias. After a prominent plane or train crash, many may profess a preference for car travel despite years of research showing that air and rail are statistically much safer. Investors sometimes look at an investment and point to an isolated incident as to why it should be owned, despite facts that show the opposite.
5. Recency Bias. When gas prices fall, sales of large sport-utility vehicles and trucks tend to rise. People believe this trend will persist. Investors tend to extrapolate the latest trends, i.e., investors continue to invest largely in technology despite prices that indicate high values.
6. Hindsight Bias. Humans tend to overestimate the accuracy of their predictions. When looking at situations from the past, we may believe we would have made the right decision. Thus, looking forward, we may be overconfident in our next decision without exploring all the facts.
7. Herd Mentality. Humans do not like to be left out of a trend or movement. Just because the larger herd is stampeding into or out of a stock, sector or region, it doesn’t mean that’s the right move for an investor with his or her own objectives.
No one of us is immune to some, or all, of these behaviors during the course of our lives. The more we are aware of them, the better equipped we can be to handle what investment markets throw our way. We can’t be perfect on every decision but if we always seek to understand the facts first and then decide, I think we can do better.