Behavioral Biases

Today we have another article in from the Financial Advisor Blog Sharing Group. This group is made up of other like-minded financial advisors from around the country. This group only includes Fee-Only financial advisors so the blog posts will be objective and free from conflicts of interest. Gregory Johnston of Johnston Investment Counsel from Peoria Illinois is the next contributor. He wrote an article about behavioral finance and the Efficient Markets Hypotheses. Here's the Article:

One of the foundational assumptions of the Efficient Markets Hypothesis is that investors are rational and always act in their best interest. Over the years, the field of behavioral finance has exploded and we have learned that humans are prone to certain behaviors that can detract from their wealth creation. Quite frankly, I’m not sure there is much we can do about them – we seem to have these biases hardwired into us.  

Perhaps the best we can do is to be aware that we have these biases and try and take thoughtful action at times of stress. Below are some of the more common behavioral biases that impact investors (in no particular order).  

Loss Aversion
People have different levels of emotions towards losses than gains.  Not surprisingly, investors are stressed more by potential losses than by possible gains. In fact, research has suggested we “feel” losses twice as much as we do gains.  

Recency Bias
We tend to extrapolate recent events into the future.  For example, according to the AAII sentiment survey, investors were the most bullish at the top of the internet bubble (early 2000) and were the most bearish at the bottom of the 2008 market crash (March 2009).  These are examples of recency bias.  

Optimism / Overconfidence
It seems that all of us are prone to think highly of our abilities and less highly of the abilities of others.  “I” am a better driver, leader, and investor than others.  Our confidence in our judgment tends to be much greater than its accuracy.  This is commonly thought of as the Lake Wobegon effect (“where all the women are strong, all the men are good looking, and all the children are above average”).  

Confirmation Bias
We like to think that we gather facts and data before coming to a well thought out conclusion.  But, often times, we reach a conclusion first and then seek facts that will support our pre-conceived conclusion.   

Herding
We tend to run in herds – we may be bullish / bearish at the same time, as well as purchase the same stocks as our friends.  Sometimes being part of the crowd can be rationalized.  However, for long-term investors, herd following tends to be detrimental to your wealth.  

Lastly, if you get really excited about “making a killing” on the new widget, talking stocks at cocktail parties, but cannot bear to open your statements at times of market stress, you may be an emotional investor.  This is a common bias but tends to have a couple of detrimental characteristics:  1) you may purchase stocks at higher valuations after all the good news is built into the price, or 2) you may do some panic selling at market lows.  

We cannot avoid many of these biases. But, if we know they exist, we can hopefully avoid some of the detrimental effects.  Remember, your emotions are often the enemy of sound financial decision making.  You will be well served by keeping your emotions in check.  

On our website, there are links to a variety of investment-related information and articles.  

About the Author

Gregory A. Johnston, CFA®, CFP®, CPWA®, QPFC, AIF® has over 25 years of investment and comprehensive finanical planning experience.  He started Johnston Investment Counsel in 1997 as an independent,  fee-only investment management and comprehensive planning firm located in Peoria, Illinois.  His clients include individuals, retirement plans, and endowments / foundations.