How Biases Can Impact Investors’ Financial Well-Being and Significantly Alter Accumulated Wealth, Part IV (a continuation of the four-part series)
Over the last three parts, we’ve discussed how biases impact our decision-making, particularly when it comes to our investments. Recognizing our biases can help us better understand why we make our financial, wealth, and investment decisions. We will conclude this series with part IV, where we will discuss the second type of the Cognitive Bias, the Information Processing Biases; and will explain how different types of Investors are susceptible to some of these different biases.
Information Processing Biases:
The following six biases arise from the individual’s irrational and flawed logic.
1. MENTAL ACCOUNTING: Individual treats various sums of money differently based on where these monies are “mentally” categorized.
- Different and unnecessary treatment of account’s “Buckets” can cause investor to neglect position that offset, complement, or correlate across account. This may lead to suboptimal aggregate portfolio performance with increased risk.
- Irrationally distinguishing between returns derived from income and those derived from capital appreciation. Investors who feel the need to preserve “Principal” and spend the interest may chase income streams and can unwittingly erode principal in the process. This could be an enormous liability on portfolios, especially in current low, near zero, or negative interest rate environments that markets around the globe are experiencing.
- Investors tend to over allocate to their employer stock when it is offered in their retirement plans, while investing in a much balanced fashion when their employer stock is not offered.
2. ANCHORING AND ADJUSTMENT: Investors are influenced by purchase point or arbitrary price level and cling to these numbers when deciding to buy or sell investments. Investors often rely too heavily on certain information (often the first data points received) when making decisions. Investors can be “anchored” on a country or company’s state of economy.
- Investor makes general market forecasts that are too close to current levels instead of making an absolute estimate based on historical risk and return data.
- Investors tend to stick too closely to their original estimates, even when new information is learned about a company. Investors may not adjust their estimates (higher or lower) because they are “anchored” to their original estimates.
- Investors tend to make return percentage forecasts based on most recent level of returns. If the S&P500 returned 10% last year, investors will be “anchored” on this number when making forecasts next year.
3. FRAMING: Experienced when investors respond to similar situations differently based on the context in which the choices are presented. Investors with Loss Aversion Bias (discussed later) who are also experiencing Framing Bias can explain excessive risk aversion, where ironically investors who have incurred a net loss become likelier to select riskier investment (in hopes they would recoup their loss), whereas investors who have incurred a net gain feel predisposed towards less risky alternatives.
- Investors responding to risk questionnaire in either unduly conservative or unduly aggrieves fashion, depending on how the question is worded.
- When long-term investors focus on short-term price fluctuations in a single industry or stock, they are experience what is called “Narrow Framing”. This risk works with myopic Loss Aversion and could lead to excessive trading by investors.
4. AVAILABILITY: This bias can influence investors when they perceive easy-to-recall outcomes (often from recent information) as being more likely to take place than those that are harder to recall or understand.
- Investors will choose investments based on information that is available to them (from Advertising, suggestions) and will not engage in a disciplined research or due diligence to verify its merits.
- Investors will choose investments based on categorical list available in their memory because other categories may not be easily recalled. Investor may ignore investing in countries where potentially rewarding investments exists because these countries may not be an easily recalled category in their mind.
- Investors will choose investments that fit their narrow range of life experiences, the industry or the region that they work or live in, or even the people that they associate with, for example, an IT engineer is heavily invests in Technology sector/companies or a healthcare provider/researcher heavily invests in Biotech and pharma companies.
5. SELF-ATTRIBUTION: Occurs when investors attribute success to their natural talent and skill and blame failures on outside influences. They disregard the fact that they just could have gotten lucky!
- Investors credit the success of their investments to their business acumen rather than factor out of their control. This can lead to another bias, Overconfidence (discussed later), which could cause excessive risk-taking as they become too confident in their behaviors.
- Lead investors to “hear what they wanted to hear”. They will attribute “Brilliance” to themselves when hearing information confirming their decisions resulting in an unnecessary purchase or delay in disposition of an asset.
- May cause corporate executives, board members, and other business owners to hold under diversified portfolios because they attribute the company’s performance to their own contributions.
6. RECENCY: Investors tend to believe that patterns, trends, and movements in the recent past are likely to repeat themselves. Individuals put too much weight on and make decisions based on inputs and feedback they have recently received which leads making forecasts that are too extreme given the uncertainty of information.
- Investors who ignore fundamental valuation and focus only on recent upward price performance may suffer principal loss when these investments revert to their long-term averages.
- Investors who ignore proper asset allocation when over allotting their investments in an investment that appears vogue and trendy at the time.
Now, and after reviewing the common biases and heuristics most investors experience when making investment decisions, it is important to state that not all investors will act the same way under the same circumstances. Different types of Behavioral Investors are prone to certain biases than other, this could also be associated with the phase of wealth creation in which investors are in.
Below are the four common Behavioral Investor Types.
1. PRESERVERS: Passive investors who place emphasis on financial security and preserving wealth rather than taking risks to grow wealth. Preservers are often subject to Endowment, Loss-Aversion, Status-Quo, Anchoring, and Mental Accounting Biases.
2. FOLLOWERS: Passive investors who don't have their own ideas about investing so they follow the lead of friends and colleagues. They are prone to follow the herd and look for the most popular investments. Followers are often subject to Recency, Hindsight, Framing, Regret-Aversion, and Cognitive Dissonance Biases.
3. INDEPENDENTS: Active investors with a higher tolerance for risk than they have need for security. They tend to get involved with investment decisions and maintain some amount of control of their own investments and likely to be more contrarian. Independent investors are subject to Conservatism, Availability, Confirmation, Representativeness, and Self-Attribution Biases.
4. ACCUMULATORS: Active investors who are often entrepreneurial and the first generation to create wealth. They are even more strong-willed and confident than independent investors and usually have a higher tolerance for risk. Accumulators are subject to Overconfidence, Self-Control, Affinity, and Illusion of Control Biases.
In conclusion, our beliefs, values, preferences, emotions, heuristics, and biases affect our thought process and subsequently how we make decisions that might seem, to ourselves at that time, as rational and logical. Our brain does an extraordinary job hiding these heuristics and biases so we do not see them. Recognizing these facts is the first step investors need to take to avoid costly financial mistakes which, in some cases, could be irreparable. Maybe you, or someone you know, thought of, or even acted upon, one of the most recent market turmoils thinking that you are making the best decision at the time, only to be surprised by a rapid market rebound that immediately followed! Of course, your brain at that time rationalized the decision to cut your losses and conserve as much as possible, when, in fact, your decision was influenced by the Prospect Theory and the Risk Aversion bias. Basic investment principals and close to 100 years of market history tells us that asset diversification and long-term investment approaches are your best hedges against significant losses, yet most investors fail to stick to and execute this “stay the course” strategy in times of uncertainty. They’re often prone to “pull the plug” and give up in the very exact market periods these hedges are built for--time of uncertainty and turmoil.
All the aforementioned heuristics and biases we explained, attest to the importance of professional advice, not only during market growth, but even more so during market contractions and periods of uncertainty. After discussing your financial goals, dreams and fears, your investment advisor should be able to draft a plan on how your assets should be invested and determine the diversified asset mix (allocations to Stocks, Bonds, Alternative Investments, and Cash) needed to achieve these goals with the appropriate level of risk you are willing to assume. Your investment advisor shall also keep you true to this pre-established long-term asset mix. As the academic studies had shown, asset allocation is the most critical decision in determining portfolio’s overall risk-return profile, and not surprisingly, is the highest contributor, over 90%, to the portfolio’s variability of return. This fact is often overlooked by investors as they incorrectly put most of their focus on trying to pick the winning names as well as timing the market. However, these latter factors contribute less than 10% to portfolios return variability. Additionally, the periodic rebalancing of your portfolio is the key to keeping the portfolio’s risk level in check, especially during periods of major market pullbacks. This might seem counter intuitive to most investors! Seriously, who would have the guts to sell winners (bonds or cash) to buy/add to the losers (stocks) in the midst of the COVID Pandemic?
Well, if you believed the market will recover, it would have been one of the best decisions you have made in the past 12 months! Nevertheless, these are heart and mind boggling, bold decisions people cannot usually take in times of mental, emotional, and possibly financial stress.
Having a trusted investment advisor by your side during these times will not only help you become a more educated and knowledgeable investor, but most importantly, will remove these emotional heuristics and biases from investing and shield your investments from experiencing potentially significant and permanent loss.
If you have a question about this article or you are interested in learning more about how First Bank Wealth Management solutions can manage your wealth, please contact your First Bank Wealth Advisor or click here to contact us.
By: George Nicola
CFP®, CIMA®, CAIA
|George Nicola is a Vice President and Senior Portfolio Manager for First Bank Wealth Management. With a deep knowledge of the market and experience in wealth management, he serves private and institutional clients with thought leadership, insight, and consulting services that are built on goals-based investment process, starting with the initial assessment and creation of an investment objective to ongoing evaluation and adjustments based on changing market and life circumstances. You may contact George Nicola at (949) 475-6304 or via email at [email protected].|