Behavioral Finance – Investor BiasesMonday, November 23rd, 2009 by Cass Chappell, CFP®
There is a popular indicator of investor sentiment that follows the net inflows and outflows into certain investments. In a nutshell, it goes like this:
o When investor inflows are at their peak, the market has traditionally gone down soon after
o When investor outflows are at their peak, the market traditionally goes up shortly after
“Why is this? Why are investors usually SO WRONG at timing their investments?”
The answer may lie in certain INVESTOR BIASES that we, as humans, have developed and intensified over time.
Misdirected Worry: More people cite being wiped out in a market crash as a greater threat to their financial security than inflation. While both are possible, historical evidence leans towards inflation as a greater threat to financial security. BUT, a crash seems “scarier”.
Snake-bite Effect: Investors may forego strong growth opportunities, regardless of whether or not the circumstances are different, if they were “bitten” before. The technology bubble bursting in 2000 did more to strengthen this bias than anything else I can think of.
House Money Effect: This one is dangerous and can be very counter-productive to an otherwise prudent investment plan. Investors may be inclined to take excess risk with money viewed as “someone else’s”. How many times have you been at a casino playing blackjack….you’re up 50 bucks and you keep playing. In some cases, you may even start betting more. Once you lose it, you think “Oh well, I broke even.” We never view it as losing 50 bucks (since you could have walked away when you were up).
Representativeness: Labeling an investment as “good” or “bad” using recent performance. This bias largely explains why investors flock to last year’s hot investment (and usually at precisely the wrong time).
Bandwagon Effect: Similar to Representativeness. This bias can cause investment bubbles to burst. The technology bubble and the housing bubble were fostered by investors eager to “get on board”.
Overconfidence: The belief that your judgment is better than it really is. People who display an overconfidence bias think that they have access to better information than everyone else and are overly optimistic about their investment outcomes. We all know one!
Endowment Effect: The bias that creates the almost impulsive instinct to hold investments they already own. Most people think much harder, and longer, about sell decisions than they do buy decisions.
Cognitive Dissonance: People tend to reconcile opposing positions or accept one and reject the other…..putting off difficult decisions because it makes us uncomfortable. Many investors don’t want to think about how spending in the present relates to future savings or retirement.
Anchoring (also known as Home Bias): People are drawn to what is familiar and comfortable. People tend to over-concentrate their 401(k)’s with the stock of their company. Investors also tend to invest a disproportionate share of their portfolio in investments within their own country, region, or industry.