A recent study shows that much of the value associated with working with an advisor comes from his or her ability to help you manage your emotions when making financial decisions.
Behavioral biases are the main reason why most investors underperform broad market indexes like the S&P 500.
These biases tend to be especially problematic during times of severe market volatility.
Established back in the 1980s by psychologist, economist and Nobel Laureate, Daniel Kahneman, the field of behavioral finance has evolved greatly over the years. Thanks to the work of visionaries like Kahneman and Richard Thaler, as well as a new generation of behavioral economists including Shlomo Benartzi, we now have a much better understanding of dozens of biases that frequently short- circuit our financial decision-making when volatility rears its head in the markets. Here are just a few of the most common biases:
Herding bias: From prehistoric times when straying from the pack and exploring the unknown could literally be lethal, the tendency to follow the crowd financially (even when it may not be in our own best interest) seems almost hardwired into our human DNA. From the Dutch “tulip mania” of the 1600s to the dot-com bubble of the late 1990s, and most recently the astronomical rise and equally rapid descent of Bitcoin, history is littered with examples of our eagerness to jump on the latest trend to appease our innate FOMO (fear of missing out).
Overconfidence bias: We tend to overestimate both what we are capable of as well as how much we know. Look no further than the oft cited 1980s psychological study which found that, despite the statistical impossibility, more than nine in ten Americans consider themselves “above-average” drivers. We reinforce this behavior as a society by valuing certainty over uncertainty—nobody ever wants to hear “I’m not sure” from their physician. Overconfidence explains why we typically expect good things rather than bad things to happen to us and is the main reason (along with loss aversion) we tend to sell our successful investments too early and hold on to our bad investments too long.
Status quo bias: We are creatures of habit who generally prefer the comfort of the familiar. Change can be intimidating, so rather than face the unknown, we tend to procrastinate and put off making important decisions. It’s one of the primary reasons why it can be difficult to convince an investor to build up an emergency fund or to create a plan to cover potential long-term care costs. In tandem with our “loss aversion bias,” it also explains why so many 401(k) savers maintain the same salary deferral percentage and default conservative allocation despite a steadily rising income.
Recency or availability bias: Explains our inclination to place far greater importance on recent news and events, rather than focusing on longer-term trends. It’s why 11+ years into the last bull run, so many investors forgot about the cyclical nature of the stock market. Fueled by the almost constant 24/7 onslaught of financial news (both online and through media outlets), recency bias also tends to lead investors to flee the market after a precipitous correction, thus missing out on the ensuing recovery.
Through the simple act of recognizing and understanding these biases, you can make tremendous strides towards overcoming them. Awareness alone, however, won’t eliminate them. Constant vigilance and expert guidance will be needed.
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1 DALBAR, July 2019. An investment cannot be made in an index.
2 Vanguard Research, “Assessing the value of advice,” September 2019.