Behavioral Finance: Understanding Bias
At Trust Company of the South, we believe markets are efficient. This means that all available information has been taken into account in real-time and is accurately reflected in current pricing. An individual trying to “time” the market or find hidden value is no match to the volume and speed at which trades are executed in the marketplace. However, market efficiency does not require all market participants to act rationally. Individuals often fall prey to behavioral biases that result in irrational decision-making, which may be detrimental to investment returns and ultimately in achieving financial goals.
A few of the most common biases advisors encounter with clients are discussed below. They should serve to highlight the importance of setting a target allocation for your portfolio and developing an investment plan so you can refer to it when you consider making changes during adverse market conditions.
This bias occurs when avoiding a potential loss takes precedence over achieving a potential gain. Because we tend to recall losses more vividly than gains, we focus on avoiding that pain to the detriment of potential gains. An example of this tendency is holding on to a losing investment for too long in order to avoid realizing a loss. On the flip side, investors may quickly sell securities that have appreciated to lock in profits.
Most people find it easier to remember what happened yesterday compared to several years ago. This can hurt us when making investment decisions. Recency bias prompts us to place too much importance on current events, which can cause hasty decisions when markets are volatile.
This is the tendency to seek information that supports your opinions and ignores information that contradicts them. Because the investor focuses on data that supports his or her decision, it reinforces that decision and leads to the belief that nothing can go wrong. This can lead to taking on too much risk in the portfolio.
Mental accounting occurs when you artificially compartmentalize money into different categories and apply different decision rules to each. The underlying concept is the fungibility of money, which means that, regardless of the origin or intended use, all money is the same and should be valued equally whether it is earned or received as a gift. Often mental accounting is applied to inherited assets. Diversifying out of Grandad’s stocks may make sense, but it’s often difficult for the recipient to sell due to the associated attachment.
Herd mentality is the tendency to follow what other investors are doing, rather than following the path that makes sense for your goals. This behavior has served humans well as a survival technique, but investors need to stay on their own course.
While everyone is susceptible to these pitfalls, there are ways to avoid them. The first step is to work with an advisor. We help identify biases and educate clients so the decisions they make are rational. We can also help reduce the effects of emotion on your wealth decisions. Your investment policy statement, which is developed based on your risk tolerance and goals, should serve as a roadmap for your decisions. Staying disciplined will serve you well in the long run and you will find it’s much easier with an advisor by your side.