Legendary economist and investor Benjamin Graham (1894–1976) made a timeless observation, decades ago: “The investor’s chief problem—and even his worst enemy—is likely to be himself.” In other words, our own behavioral biases are often the greatest threat to our financial well-being. As investors, we tend to leap before we look; we stay when we should go; we cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done.
It's important to understand, however, that most of the behavioral biases that influence our investment decisions come from the mental shortcuts humans have evolved in order to think and act more effectively. Usually, these short-cuts work well for us. For example, they can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we’re simply trying to stay afloat in the rushing roar of deliberations and decisions we face every day.
But, as we’ll cover in this series, those same survival-driven instincts that are otherwise so helpful can turn deadly in investing. They overlap with one another, gang up on us, confuse us, and contribute to multiple levels of damage done. Because the human nervous system didn’t evolve in an environment that included information that travels at the speed of light, connecting sources of input from all over the world in nanoseconds, it is ill-equipped to handle the challenges of making split-second choices (at least, correct ones) in the computer-driven financial markets of today.
Nevertheless, behavioral biases are a formidable force. Even after you know they’re there, you’ll probably still experience them. It’s what your brain does with the chemically induced instincts that fire off in your head long before your higher functions kick in. They trick us into wallowing in what financial author and neurologist William J. Bernstein describes as a “Petrie dish of financially pathologic behavior,” including:
Counterproductive trading: incurring more trading expenses than necessary, buying when prices are high and selling when they’re low.
Excessive risk-taking: rejecting the “risk insurance” that global diversification provides and instead over-concentrating in recent winners and abandoning recent losers.
Favoring emotions over evidence: disregarding decades of evidence-based advice on investment best practices.
In this multipart series, we’ll offer an introduction to these and other damaging behavioral biases, enabling you to more readily recognize and defend against them the next time they’re happening to you.
Here are two additional defenses against the behaviorally biased enemy within:
Anchor your investing in a solid plan. By anchoring your trading activities in a carefully constructed plan (with predetermined asset allocations that reflect your personal goals and risk tolerances), you’ll stand a much better chance of overcoming the bias-driven distractions that rock your resolve along the way.
Don’t go it alone. Just as you can’t see your face without the benefit of a mirror, your brain has a difficult time “seeing” its own biases. Having an objective advisor—preferably one well-versed in behavioral finance, with a fiduciary obligation to serving your best financial interests, and who is unafraid to show you what you cannot see for yourself—is among your strongest defenses against all of the biases we’ll present throughout the rest of this series.
As fiduciary wealth advisors, we are trained to seek solid evidence, based on sound financial research, for every recommendation we make to our clients. If you would like to learn more about how we can put that expertise to work for you, please contact us.