By Mitchell Barr, Client Associate
Whether we will admit it or not, humans are inherently biased when making decisions. Think about the last time you looked back on a decision and thought, “I can’t believe I did that.” It has nothing to do with how smart we are or how much experience we have in a particular area; sometimes we just fall victim to what are known as cognitive biases, heuristics, or simply rules of thumb. The most famous of these is the Placebo effect, popular in medical studies, which states that if we believe something will have a particular effect, it often will (check out this article from Harvard Magazine1 ).
There are many other cognitive biases that have been researched over the years and almost all of them can be applicable to making financial decisions. A few in particular stand out as mistakes that everyone can relate to throughout a lifetime of financial decisions. Maybe, just maybe, if we understand these biases and how they affect our decisions, we can avoid the next financial pitfall. You may see just how difficult this can be by the end of this blog post.
The Availability Heuristic2
There is a TV commercial for an online trading platform that is a perfect example of the Availability Heuristic. A spectacled man with gray hair is sitting in an airport waiting for his flight, when he looks up and sees two restaurants in the food court. One restaurant, a burger place, is empty. The other, a healthy food joint, has a line all the way down the terminal. The savvy investor immediately goes to his computer to research the company’s stock while Kevin Spacey narrates the man’s ingenuity. At the end, he purchases a few hundred shares and pats himself on the back. The fact that the healthy restaurant had a long line at one airport has no implications on how the stock will perform in the future (maybe the burger joint had roaches), but the availability of the information caused the man to overestimate how useful it was.
This heuristic can also explain why people are often more comfortable owning stocks in their home country. We are familiar with the companies, so we feel more comfortable owning them. But just because we know the company Apple (AAPL) and not Itau Unibanco Holding SA (ITUB), it doesn’t mean it will outperform. We are constantly exposed to Apple through television, social media, and their ubiquitous products, so we will determine it is better to put our money there. (For the record, year to date as of June 30, 2016, Apple returned -8.14 percent while ITUB returned 47.91 percent, Source: Morningstar).
The Recency Effect3
The Recency Effect is everywhere in investing. Remember when everyone thought returns would always be 15 percent a year during the tech bubble? At the time, people were focused on the recent run up in the stock market and were convinced that it would go on forever. Simply stated, we overemphasize recent information that is easily available in our short-term memory. Of course, the tech bubble burst in 2000 and the S&P 500 returned -9.11 percent, -11.89 percent and -22.1 percent in ’00, ’01, and ’02 respectively (Source: 2015 Callan Periodic Chart of Investment Returns).
The Recency Effect fuels stock market bubbles. We think the good times will continue forever and tend to go all-in just before they turn for the worse. On the other hand, when a negative event happens, like the sub-prime mortgage crisis in 2008, we become convinced that stuffing cash under the mattress is the only safe place for our retirement savings long after the storm is over. It’s difficult to see the big picture because the Recency Effect is clouding our vision. Over the long run, stock prices will go up or no one would buy them. Yet, it’s not so easy to recognize that when your retirement savings just got chopped in half. Being aware of the Recency Effect can bring focus back to a broader perspective so we can avoid getting in or out of the market at the exact wrong time.
Survivorship Bias4
Do you ever wonder why you never see mutual funds with a 1-star Morningstar rating on an advertisement for a fund company? It’s logical that the company will market its best performing funds — those with a 4- or 5-star rating — to entice investors to pile money into them. But what about funds that haven’t performed well over the past few years? If you do some research, it will be difficult to find any information on them. Survivorship bias causes us to discount failed examples (in this case, mutual funds) and focus on only the ones that survive. We often overestimate the talents of fund managers because we only focus on the winners and don’t consider the losers. The fund manager with a 5-star rating might be managing his 5th different fund after 4 failures, but this year he made a few lucky stock picks and his fund took off. This type of cherry picking is rampant in investing, which is why it is important to dig up the losers every time you find a winner.
The Bandwagon Effect5
You may have also heard this called a feedback loop. My favorite example of this is the mass media. There are literally millions of stories that the media can broadcast every day. Yet, no matter which television channel we turn to, they are often talking about the same five stories. Why is this? Some of the stories are the most important news of that day and every station is going to cover them, but some aren’t any more important than any other story. And yet, they catch fire. Think about the last viral video you saw plastered on the news (my favorite is the black bear that walks on two legs like a human). A positive feedback loop drives viral videos as more and more people view them.
The same thing happens in financial media. On a given day, a pundit on CNBC will talk about why oil will be at $90 a barrel by the end of the year and suddenly nearly every network is talking about oil prices. The more people talk about the idea, the more steam it generates. Even if you are a levelheaded person, you may second-guess your judgement because so many others have a differing opinion. This phenomenon can make it difficult to figure out who or what to believe. It’s important to be cautious and attentive to what we are watching and reading, and who we are listening to for advice in order to make informed financial decisions.
The Bias Blind Spot6
We are now aware of a few biases that can affect our financial decision-making. Do you remember when I said it could be difficult to avoid those tendencies even when we’re aware of them? Enter the Bias Blind Spot, which says that we have a hard time recognizing our own biases, even though we can usually point them out in other people. When your friend Kate is talking about a new mutual fund that seems too good to be true, you might say to her, “What about all the other funds that the company offers?” You know she is falling victim to Survivorship Bias, yet you would probably make the same mistake if you were in her shoes. Isn’t that a kick in the shin?
What should we do about these biases to increase our chances of making good financial decisions? One way to avoid susceptibility to a bias is to remove emotion from decision-making. A good example is using a systematic process to invest, such as setting a long-term allocation and rebalancing to stick with it. This process is the backbone of the investing philosophy at Versant Capital Management. Versant’s investment professionals are aware that decision-making is affected by emotion and bias, so we create checks on our judgement to ensure we are prudent decision makers. Before an investment decision is made, we will understand how it effects the your long-term allocation and think twice before making the final determination.
This same principal can be applied to other things in life. Set a goal, and every time you make a decision, refer to the goal to see if it fits. Many times you will realize that the decisions you make deviate from the goal. Every human is subject to these biases and rules of thumb. We often aren’t aware of them and we may not even admit that we have them. Knowing about these inclinations can help us make better financial decisions by excluding them from the process and keeping the focus on long-term goals.
- Feinberg, C. (2013, January/February). The Placebo Phenomenon. Retrieved July 29, 2016, from http://harvardmagazine.com/2013/01/the-placebo-phenomenon
- Kahneman, Daniel. Thinking, Fast and Slow. Penguin Books Limited, ©2011, 137-145.
- Murdock, B. B. (1962). The serial position effect of free recall. Journal of Experimental Psychology, 64(5), 482–488.
- Carhart, M. M. (n.d.). Mutual Fund Survivorship. SSRN Electronic Journal SSRN Journal. doi:10.2139/ssrn.36091
- Shiller, R. J. (2000). Irrational exuberance. Princeton, NJ: Princeton University Press, 85-87.
- Scopelliti, I., Morewedge, C. K., Mccormick, E., Min, H. L., Lebrecht, S., & Kassam, K. S. (2015). Bias Blind Spot: Structure, Measurement, and Consequences. Management Science, 61(10), 2468-2486. doi:10.1287/mnsc.2014.2096
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