This series of articles provides a look at some of the emotional and behavioral biases—most of which are unconscious—that can affect investing behavior in ways that aren't usually helpful for achieving the best long-term results. In our previous article in the series, we examined confirmation bias and familiarity bias.
Today, picking back up in the “F’s” of the behavioral bias alphabet, we’ll start with one that needs little introduction.
Fear. As Jason Zweig describes in Your Money and Your Brain, if your brain perceives a threat, it spews chemicals like corticosterone that “flood your body with fear signals before you are consciously aware of being afraid.” Some researchers have suggested that this isn’t really “fear,” since you don’t have time to think before you act. Call it what you will, this bias can heavily influence your next moves—for better or worse. Of course, there are times you probably should be afraid enough to react instantly, such as when an urgent life-saving act is required (running away from physical danger, for example). This instinct helped our ancestors survive long enough to become our ancestors. However, researchers have noted that our brain reacts to a plummeting stock market in the same way it responds to a physical threat like a predator. While the fear instinct could save your life out in the wild, in the investment landscape it can send you over a cliff. Also, our financial fears are often misplaced. We tend to overcompensate for more memorable risks (like a flash crash), while ignoring more subtle ones that can be just as harmful or much easier to prevent (like inflation, eroding your spending power over time).
Greed. At the other end of the spectrum lies another familiar emotional risk: greed. In investing, the term usually refers to our tendency to chase “hot” stocks, sectors, or markets, hoping to score larger-than-life returns. In doing so, we ignore the oversized risks typically involved as well. Many of us are familiar with Gordon Gekko, the character in Oliver Stone’s Oscar-winning Wall Street. Gekko’s famous line, “Greed … is good,” is actually true—up to a point. There really are times when a little greed—or maybe we should call it “ambition”—can inspire greater achievements. On the other hand, in our fast-moving financial markets, greed and fear become a two-sided coin that you flip at your own peril. Heads or tails, both are accompanied by chemical responses to stimuli we’re unaware of and have no control over. Overindulging in either extreme leads to unnecessary trading—including heavy trading expenses—at inopportune times. As Berkshire Hathaway Chairman and CEO Warren Buffett has famously said, “Investors should remember that ... they should try to be fearful when others are greedy and greedy only when others are fearful.”
Herd mentality. Much like cattle and other animals that organize themselves in herds, humans instinctively recoil from or rush headlong into excitement when we see others doing the same. “[T]he idea that people conform to the behavior of others is among the most accepted principles of psychology,” say Gary Belsky and Thomas Gilovich in Why Smart People Make Big Money Mistakes. If you’ve ever gone to a highly touted new restaurant, followed a fashion trend, or binge-watched a hit series, you’ve been influenced by herd mentality. “Mostly such conformity is a good thing, and it’s one of the reasons that societies are able to function,” say Belsky and Gilovich. It helps us create order out of chaos in traffic, legal, and governmental systems alike. But whenever a sector of the market is on a hot run or in a cold plunge, herd mentality intensifies our greedy or fearful chain reaction to the random events that generated the excitement to begin with. Once the dust settles, those who have reacted to the near-term noise are usually the ones who end up overpaying for the “privilege” of chasing or fleeing temporary trends instead of staying the course toward their long-term goals.
As professional, fiduciary wealth managers and financial advisors, we are trained to help our clients recognize and counteract behavioral biases as we work with them to build well diversified portfolios. If you’d like to learn more about how we work to help our clients build portfolios, please contact us and ask for a copy of our white paper, Evidence-Based Investing: 12 Principles for Growing Your Wealth over the Long-term.