Investing is an emotional process; you are putting your hard-earned money into an inherently uncertain market. You can use multiple sources to research potential investment opportunities before making a final decision, but no matter how informed you are there are likely cognitive biases that may influence your final decision. This does not mean that it will result in a bad decision, but instead that you may have overlooked or misinterpreted an important factor or better opportunity.
Behavioral economics is the idea that people’s choices are influenced by psychological phenomena. This theory assumes that people try to be rational, make choices that will maximize utility, but that in many scenarios people’s rationality is bounded causing them to make choices inconsistent with their preferences due to biases and heuristics. A cognitive bias is a systematic error in thinking that occurs when people are processing and interpreting information. Heuristics are cognitive shortcuts we use to simplify problems. Heuristics can generally be thought of as a rule of thumb for an individual. They can be helpful for making quick decisions but sometimes cause us to overlook everything that factors into the decision.
There are a plethora of biases and heuristics that exist, but the following are examples that may be relevant to your decision process as an investor.
The affect heuristic is the idea that current emotions influence decision making. As I mentioned, investing is very emotional. Recently investors may have been feeling anxious about volatility in the market and the impact it’s had. That anxiety may make an investor want to pull money out of the market whereas if the market were in an upswing an investor might think it’s a good time to put more money in. Neither is necessarily a wrong decision, but it is the anxiety about volatility and the confidence about an upswing that may be influencing those decisions.
Present bias is a bias that is prevalent in investing. It is the idea that people focus more on the present than long-run preferences would suggest is optimal. This is phenomena can often be observed in retirement planning. One example is the desire to not contribute as much as you should be into your retirement account because it leaves you with less spending money now, however if you do not contribute now, then you may not have the assets necessary to retire comfortably.
The availability heuristic is when one assesses quality or risk based on how easily a topic comes to mind. When you think of activewear company’s the first one that comes to mind might be Nike, so your brain thinks, Nike is a good company. This may be true, but you probably should not base your investment decisions on the first company that comes to mind without conducting due diligence.
Confirmation bias is one that may sound familiar. This is the idea that people evaluate or seek information that fits their personal beliefs. This could certainly have a negative impact on investment decision making. If someone is deciding between investing in two different companies and strongly believes one is better for whatever reason they may look for data that confirms that, even if based on all the information the other company is objectively a better investment.
Loss aversion is when people weigh losses more than gains. This bias is very interesting and a good way to think about it is through messaging. For example, “Take these vitamins to avoid illness” vs “Take these vitamins to be healthier”. In this scenario illness is a loss, loss of time, health, happiness, etc., so people are more likely to take the vitamins for that reason than for the gain of health. In investing, you may see a $500,000 investment that has lost $1,000 and think that’s a huge loss. On the other hand, if it had gained $1,000 you may think nothing of it because it does not seem like that much for that sizeable of an investment.
The status quo bias is the preference to keep things as is over making changes. This is something that can commonly be observed in investing. Say your company’s 401(k) plan just added some new investment options and kept all the old ones as well. You decide to make no changes because your current allocation is performing fine. You may have missed an opportunity for an allocation that performs great because of a status quo bias.
These biases and heuristics likely exist in all of us, and they are not necessarily bad to have, it is natural, however learning about them can help us to make better decisions. The next time you make a decision you may recognize that one of these phenomena’s is impacting your thought process. That awareness can allow you to take on a different perspective. You may still come to the same conclusion in the end but considering all available information accurately can help you have more confidence in your decisions and, potentially, better outcomes.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Jim Hyre and not necessarily those of Raymond James.