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Recognizing Bias

We all like to think of ourselves as rational human beings. In reality, every one of us is prone to dozens of biases that make us think and act irrationally. Sometimes, we are aware of our biases; more often, we are not. There is an entire field of study on cognitive biases and human behavior. In fact, even simply thinking that we are rational people while knowing there is irrationality in others is called blind-spot bias. Understanding this can help us recognize when a bias is at work and can give us valuable insights into our thinking. Ultimately, those insights can help us become better decision-makers when it comes to investing.

Loss Aversion

I saw an interesting YouTube video in which a man tried to make bets with people on the street. He offered to flip a coin and, depending on the outcome, either he would pay them $10 or they would pay him $10. Nobody took the bet. When he offered to pay up to $50 if he lost against just $10 if they lost, many still would not take the bet. Loss aversion is a common bias in which people feel the pain of a loss more deeply than they feel the joy of a gain. As an investment advisor, I get many more phone calls from clients when there is a market downturn than when the market is doing well. People remember years when they lost 20% (does 2008 ring a bell?) but don’t remember the years when the market rose 30% — I challenge you to name one such year. What to do? Since our memories tend to focus on losses, it is important to remind ourselves of the good years, to remember that there is balance in the market and historically, the market has more good years than bad. Keep this in mind when you start to feel uncomfortable with risk in your portfolio.

Confirmation Bias

I have met many people who invest a disproportionate amount of money in the company they work for or a company they particularly like, which can make a portfolio less diversified and therefore extremely risky. For example, in 2001, many employees of Enron had chosen to purchase Enron stock through the company 401(k) plan and lost the bulk of their retirement savings when the stock dropped 94%. Confirmation bias is the tendency of people to be drawn to information and ideas that validate their existing beliefs and opinions. When it comes to investing, you can overcome this by relying on information from multiple sources, which may provide a more complete picture of the information available. Generally, sound advice will be repeated by various reputable sources.

 

Recency Bias

If you are a sports fan, you have probably experienced both excitement and disappointment, depending on how well your team is playing. I know I am most excited about the Cardinals when they are on a winning streak. When they have been recently winning, I expect them to continue winning. People tend to believe that whatever is happening now, or recently, will continue to happen. Another example is when gas prices drop, large vehicle purchases increase. Or, in 2008, as housing prices hit all-time highs, people continued to pay inflated prices for homes, thinking the prices would climb even higher. When it comes to investing, keep in mind that just because the markets have recently dropped or risen means nothing when it comes to tomorrow’s performance. That is why you so often hear “past performance is no guarantee of future results.”

Whether we realize it or not, we all have biases in our thinking. These are just a few of them. Perhaps we will never be completely rational. But, being aware of these and other biases can help us put our thinking in perspective and, hopefully, make us better investors. FBN

By Glenn Leest

Glenn Leest is a local investment advisor at WT Wealth Management located at 809 W. Riordan Road, Suite 206 in Flagstaff. You can contact Glenn for a no-cost consultation at 928-225-2474 or at GLeest@WTWealthManagement.com.

 

 

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