All of us like to think we are rational beings, weighing the pros and cons of a situation and then making a well-informed decision. What we sometimes don’t realize is there are forces at work in our subconscious which can sway us toward irrationality at precisely the wrong time. However, if we take the time to examine what those forces are and how they affect our decision-making, we should be able to recognize and avoid some of the misdirection in our lives.
Behavioral finance is a study in both finance and human behavior and seeks to understand how people make financial decisions, what factors influence them, and how to help them make better decisions. These forces, or biases can skew our decision-making and act in such subtle ways that we may not even know they are at work. Biases in the financial realm are particularly fascinating, as they can move entire markets or simply prevent one individual from taking the next critical step in securing their financial future. These may be deep-rooted in our family history, cultural or religious based, or a result of our education and employment history. Sometimes we are biased because of emotional baggage, needing to ensure we “never lose” or we are “always accepted.” In each case, these can lead to the reality of seemingly rational people making very irrational decisions about money.
Many of you have probably heard of the more common investor biases. These include Crowd-Following, Overconfidence and Loss Aversion, among others. They can cause irrational investor behavior and unanticipated consequences throughout the market cycle.
Crowd-following or Herd Mentality
You may have heard the concept that within a herd, if you get just a few of the herd moving in the desired direction, the rest will typically blindly follow, even to their deaths. Research has shown that it takes a minority of only five percent to influence a crowd’s direction, and the other 95 percent follow without even realizing it.*
If you look at the business cycle chart to the right, near the top of the market between “thrill” and “euphoria,” you can see the herd at work. By the time you reach the “thrill” point in the cycle, you’ve missed out on much of the positive market movement, although typically there is still a lot of negative news in the media during this period of time. It hadn’t yet “felt” like a recovery, because the constant deluge of information by the media skews our perceptions of reality. When the media finally begins to report good news in the economy, consumers finally feel it is safe to re-engage in the equity markets. The “herd” moves into equities in mass, but because they are simply reacting to the media noise, they are typically too late to reap any substantial rewards.
There is a phenomenon that occurs in the markets near the top of a business cycle when rational investors take their gains and move on, while others allow greed and overconfidence to keep them hoping for more. The moment it moves from having nice gains to, “I am the smartest stock picker in the world,” is when greed gets the best of investors. Their overconfidence is typically unfounded and their actions are likely being reinforced by the media hype. Overconfidence can lead consumers down a slippery slope as the markets turn and begin to decline.
Investors do not like losses, even paper losses that have not yet been realized. If investors bought near the market top and now regret that move, they will likely hold on tightest on the way down to avoid defeat at all cost. This desire motivates some investors to hold a stock in the face of contradictory news simply to avoid realizing a loss. This mentality gets in the way of rationality by making investors hold investments “just until they recover their costs.” This is typically due to an unspoken need to not lose, even when hard facts are telling them otherwise. Extreme loss aversion can cause an investor to ride a bad investment out of existence even though rationally they know their remaining money could be put to better use elsewhere.
While the above investor biases may be most familiar to you, there are other biases which are less obvious but equally dangerous if they are undermining your best decision-making.
Family of Origin
If we begin by exploring those aspects of our decision-making which are a result of our family of origin, we may discover strong biases that work in almost subconscious ways. Much can be learned from exploring how the family who raised you made decisions. Was there a strong dictatorial presence or were issues discussed and resolved democratically? Was money a source of problems, either from the lack of it or the over-abundance of it? Was money used as a means of control over others? Did you grow up feeling poor and dependent on others, or was your family the one who helped others in times of need? All these things can work to sway our decisions, even when we are not aware of it. Is it possible you are a spendthrift today because every penny was accounted for growing up? Or are you a saver, maybe to the extreme, trying to ensure members of your family don’t have the same difficulties you had as a child? While we cannot change how we grew up or the influence these events had on our lives, we can examine and be aware that some of our irrational decisions are being shaped by the past.
Employer or industry
Many consumers exhibit familiarity bias or company specific bias when considering their employer as an investment. An employee’s human capital (the ability and willingness to earn income) is tied up in their employer. It is logical that an employee may have an unsubstantiated bias toward the company. They are confident that the company will continue to perform well, despite the fact, in many cases, they see only a small portion of the overall company’s performance on a daily basis. Unless the employee is part of the inner circle of upper management, they usually have an “in the weeds” mentality. They cannot see the bigger picture of how the company is actually doing as a whole, because they are in the weeds of their specific, isolated position.
When employees become too biased toward their employer they risk placing too many of their financial eggs in their employer basket, potentially ruining their financial future should the company stumble. We have seen the effect of employees loading up on employer stock, through concentrations within their 401(k) plan, stock purchase plans or options and grants. In the mid-2000’s, employees were alarmingly overconfident with regard to employer stock, resisting diversification until it got just a bit higher, then higher still. They added to deferred compensation programs which deferred immediate taxation but had the potential to backfire if the company became insolvent. They also used their employer benefits as the sole provider for life and disability insurance, putting themselves and their families at risk if their employer ever chose to sever the employee relationship. They saw no risk in this because, they rationalized, they were “in the know” and all signs pointed towards a positive future. Despite warnings to the contrary, they tied both their human capital and their investment capital to the same company and for some, the crash of 2008/2009 resulted in worthless holdings of employer stock and a bleak future for a now, ex-employee.
Because we are familiar with our employer and our industry, we can easily become biased and end up with a concentrated portfolio that puts our future at risk. Diversification is a means of protecting against that familiarity and company bias. This holds true for investments, as well as diversifying between private and group coverage for insurance. There is great value in not having all your eggs in one basket and having a comprehensive viewpoint to examine risks to your future from all angles.
The “superman” bias is widespread in teenagers, who believe they are invincible, but it can also exist in adults who feel like bad things only happen to other people. There are those who have been told they need to have an estate plan in place to protect their loved-ones when they die. They resist discussions about death and dying because it is uncomfortable to think about and the decisions are sometimes fraught with difficulty. They may also carry a bias because a parent or other loved one lived well into their 90’s so they continue to put off dealing with those issues. Emotions and fear often get in the way of rational, logical behavior. However, we all know the unthinkable can happen to any of us, at any time. Therefore, it is imperative that proper planning take priority over our feelings of invincibility.
Biases exist in all parts of our financial lives, whether we recognize them or not. Learning more about the biases that may be influencing us can provide some insight as to how we may be irrationally led to a particular decision. Because we are sometimes too close to these biases to see them clearly, it is also extremely helpful to engage outside professionals to work on our behalf to provide a more unbiased view of the situation. While professionals are not immune to these biases, they are well trained to operate in an un-emotional, rational manner. The best advisors research extensively and put disciplined procedures in place to sift through surrounding noise in order to properly analyze underlying data when making decisions.
In addition to disciplined research and procedures, a comprehensive advisor can help you examine your own biases and identify when they are getting in the way of rational decision-making. You owe it to yourself to partner with a professional who can help you evaluate your situation from a comprehensive, un-biased viewpoint so that the financial decisions you make throughout your life will truly be the best decisions to successfully navigate the future.