In our last visit to the “ABCs” of behavioral investing, we looked at fear, greed, and the herd mentality and how they can work together to both instigate and amplify bad investing decisions. As we noted, each of these instincts, hard-wired into our nervous systems, can have beneficial effects, because each developed in order to keep us safe or help us take advantage of favorable circumstances. But as we’re learning, in the world of financial markets and investing, emotion-driven responses are more likely to harm than to help.
This time, let’s start with a trait we’re all familiar with.
1. Hindsight. We all know the proverb, “Hindsight is 20/20.” And it’s true; it’s always easier to see what we should have said or done than to make the right decision about what comes next. But hindsight has another quality tied to our nervous system that should make us think twice. Daniel Kahneman, in his book Thinking Fast and Slow, describes hindsight as a “robust cognitive illusion” that causes us to believe our memory is correct when it is not. For example, say you expected a candidate to lose, but she ended up winning. When asked afterward how strongly you predicted the actual outcome, you’re likely to recall giving it higher odds than you originally did. While giving ourselves more credit than we’ve earned can be helpful psychologically—such as when it helps us take a more optimistic view of life—it can be detrimental in investing, since your best financial decisions come from realistic assessments of market risks and rewards. If a high-risk investment happens to outperform, but you conveniently forget how risky it truly was, you may load up on too much of it and not be so lucky moving forward. On the flip side, you may too quickly abandon an underperforming asset, telling yourself, in effect, “I knew it was a bad idea, all along.”
2. Loss aversion. Another feeling we’re all familiar with, loss aversion is the “glass half-empty” feeling we get when we evaluate a situation or opportunity. It’s a fancy way of saying we often fear losing more than we crave winning. This leads to some interesting results when balancing risks and rewards. For example, in his book Stumbling on Happiness, Daniel Gilbert says, “… most of us would refuse a bet that gives us an 85 percent chance of doubling our life savings and a 15 percent chance of losing it.” Even though the odds favor a big win, imagining that smaller chance that you might go broke leads most people to decide it’s just not worth the risk. Of course, it’s not a bad thing to try to stay on the right side of probability; that’s why people buy insurance, after all. But this trait is also easily observed by those who “sit on the sidelines,” holding everything in cash during a bear market—or even in a bull market that they believe is overdue for a correction. Even though extensive research and historical evidence tell us that we should expect to end up with higher long-term returns by at least staying put, if not bulking up on stocks when they are “cheap,” the potential for future loss can frighten us into abandoning our carefully planned course toward the likelihood of long-term returns.
3. Mental accounting. This happens when we mentally assign “buckets” to certain holdings. If you’ve ever treated one dollar differently from another when assessing its worth, that’s mental accounting at play. For example, if you assume inherited money must be more responsibly managed than money you’ve won in a raffle, you’re engaging in mental accounting. This works in our favor when, for example, we’re saving up for a vacation and we label certain funds as “the vacation money.” It can help us save and spend wisely. But what if you’re emotionally attached to a stock you inherited from a beloved aunt? You may be unwilling to unload it, even if reason and your overall investment strategy dictate that you should. You’ve just mentally accounted your aunt’s bequest into a place that detracts from rather than contributes to your best financial interests.
4. Outcome bias. Sometimes, good or bad outcomes are the result of good or bad decisions; other times (such as when you try to forecast future market movements), it’s just random luck. Outcome bias is when you mistake that luck as skill. This emotional trait is rarely helpful, because, as Kahneman says, it “makes it almost impossible to evaluate a decision properly—in terms of the beliefs that were reasonable when the decision was made.” The more we happen to come out ahead on lucky bets, the more we may mistakenly believe there’s more than just luck at play. “I’d rather be lucky than good” makes for an amusing remark, but as an investment philosophy, it’s a disaster waiting to happen.
At Bernhardt Wealth Management, we provide evidence-based, research-tested investment management advice to our clients. As fiduciaries, we are ethically and professionally obligated to always place the client’s best interest foremost. To learn more about the foundational principles behind our advising practice, click here. And to speak with us about your investing and wealth management questions, please contact us.