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Your Brain and Investing: Sixth in an Occasional Series

As we enter the “home stretch” in our look at the “ABC’s” of behavioral investing, it might be important to reflect, for a moment, on how we started. Too often, investors’ own behavioral biases are often the greatest threat to their financial well-being. Or, as Benjamin Graham (1894-1976) wisely stated, so many years ago: “The investor’s chief problem—and even his worst enemy—is likely to be himself.” With that thought in mind, we’ve been taking a quick tour through various emotional and mental biases that tend to interfere with our ability to make the most appropriate decisions about investing in today’s financial markets. The problem, as we’ve seen, is that because most of these biases are the result of millennia of evolution in the human nervous system, we don’t recognize them as problems; they seem “perfectly natural.” But we have to remember that the assumptions and behaviors that helped our ancient forebears stay safe in an uncertain natural environment may not be the most advantageous tools to use in the computerized, almost-instantaneous environment of the modern financial markets.

This time, we’ll finish the “O’s” of behavioral investing with a discussion of a trait that has ambushed many a sports team and poker player.

Overconfidence. Like many “positive” traits, overconfidence is like the mirror-image of a more “negative” trait: loss aversion. You might recall that loss aversion causes us to overvalue something we’ve obtained, which, in the case of investing, can mean hanging onto an investment that may be either wildly overvalued or no longer helpful for achieving our long-term goals. On the flipside, overconfidence—usually working in tandem with other biases such as confirmation bias and familiarity bias—puffs up our belief that we can consistently beat the market by being smarter or luckier than average. In reality, when it’s you, betting against the trillions and trillions of other dollars at play in our global markets, it’s best to be brutally realistic about how to patiently participate in the market’s expected returns, instead of trying to go for broke (sometimes, literally).

Pattern recognition. Is that a zebra, a cheetah, or merely a light breeze moving through the tall grass? Since prehistoric times, when our ancestors depended on quickly getting the right answer to such questions, evolution has been conditioning our brains to find and interpret patterns. That’s why, our pattern-seeking impulses tend to treat even random events (like 10 coin flips, all heads) as if they’re orderly outcomes suggesting a predictive pattern. “Just as nature abhors a vacuum, people hate randomness,” says Jason Zweig, author of Your Money and Your Brain. As a result of our brain’s dopamine-induced “prediction addiction,” we tend to see patterns, even when they aren’t there. While pattern recognition is invaluable when, say, you’re enjoying a good jigsaw puzzle, solving a Sudoku, or manipulating a Rubik’s Cube, it can actually be harmful when making decisions based on the events of a day—or even a month—in the financial markets. For example, a recent study released by researchers at the Cox Business School at Southern Methodist University and at the University of Miami found that individuals will tend to react negatively to financial information printed in red ink, even when the information is of a positive nature. Why? Because our pattern-seeking brains have “learned” that “red” equals “bad” in finance. In other words, pattern recognition tends to cause us to “see” things that aren’t really there—a bad outcome when making important investing decisions.

Recency bias. As its name implies, this trait causes you to pay more attention to your most recent experiences and to downplay the significance of long-term conditions. For example, in their book Nudge: Improving Decisions About Health, Wealth, and Happiness, Nobel laureate Richard Thaler and co-author Cass Sunstein observe: “If floods have not occurred in the immediate past, people who live on floodplains are far less likely to purchase insurance.” That’s recency bias at work, tricking people into ascribing more importance to the lack of recent flooding than to the bigger context of being located on a flood plain. In an investing context, recency bias causes droves of investors to stumble every time. By reacting to the most recent jolts instead of remaining positioned as planned for long-term expected growth, they end up piling into high-priced, “hot” holdings and locking in losses by selling low during the downturns. They allow recency bias to get the better of them, instead of making rational, evidence-based investment decisions.

In our next installment in this series, we’ll finish our tour through the alphabet and end our look at common behavioral investing traits that tend to derail most investors from their course toward long-term financial and investing success. In the meantime, if the fiduciary professionals at Modera Wealth Management can help you take a better, more logical look at your portfolio or answer a question about your long-term financial planning, please contact us.

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