Market Minute - September 11, 2017
by Scott Rosenquist, CFA
Behavioral finance introduces the idea of biases investors exhibit and how they can affect decision making. In the previous post I discussed loss-aversion, an emotional bias whereby investors feel the pain of losses more than the pleasure of gains. We identified how this could lead to irrational decisions to avoid taking a loss.
Continuing on the topic, behavioral biases in investing can be broken down into two broad categories: cognitive and emotional. Cognitive biases are based on how people think and process information, while emotional biases are related to how people feel and how it influences the decision-making process. There are several biases that fall into each category and many of them are related. I’ll discuss one of each including an example of a potential ramification.
Recency bias: A cognitive bias that occurs when people put more weight on recent events while making investment decisions. New pieces of information can be easier to recall and are given more value while older data may be dismissed. This bias is commonly found at market peaks (Real Estate, Technology) and market bottoms (Great Recession) when investors project past returns into the future. As a result, investors put more consideration into what is currently happening in the market in hopes to replicate the results. This could lead to a portfolio design that does not match their risk tolerance and financial goals.
To counteract this bias, obtaining education of financial markets, past and present, and focusing on long-term goals can help. Discussing new investments and changes with your Relationship Manager can also help identify whether new opportunities truly align with your long-term goals and current portfolio design. Having a sound investment process will help develop disciplined decision-making that is not easily influenced by the most recent information obtained.
Endowment bias: An emotional bias where people place a higher value on an asset simply because they already own it. For example, when an individual has inherited a large stock position they may place an irrationally higher value on that position than the actual market value because it may feel familiar and even sentimental, whether or not the position fits well with their financial plan. This could lead to the potential risk of being stuck in a concentrated position or the loss of opportunity to move toward better positioning for market conditions.
To help offset this bias, a good practice is to consider whether you would purchase the position again if you had the equivalent of cash available. Another option to help deal with this bias is to slowly divest out from the position over time to help ease the emotional tug.
While everyone has biases when it comes to decision making, it is important to be aware of them and their potential effects. Cognitive biases can be addressed through education while emotional biases can be more difficult to identify and change. One way to help mitigate an emotional bias is to ask questions that can help move towards a rational investment process. Acknowledging that these biases are present and finding ways to minimize their effect could help investors reach their long term financial goals.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to nor does it represent or reflect transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.