Your Brain and Investing: Second in an Occasional Series
Updated: Mar 13
In the first article of this series, we introduced the broad concepts of behavioral investing, especially the ways in which our human instincts and behaviors—evolved over millennia to keep us safe from environmental threats—tend to work against us when it comes to making sound decisions for investing in today’s financial markets. In this article, we’ll take a closer look at a couple of those behaviors and analyze why they often lead us to make decisions that are detrimental to portfolio performance over the long haul.
As we move through the “ABCs of behavioral investing,” we’ll cover most of the common behavioral biases that tend to derail investors’ carefully designed strategies with “spur-of-the-moment” decisions that seem right at the time, but that typically don’t pan out, long-term. (And don’t worry: there’s not a specific behavior for every letter of the alphabet!)
Anchoring Bias. This behavioral bias occurs when you fix on or “anchor” your decisions to a reference point, whether or not it’s a valid one. An anchor point can be helpful when it is relevant to living more efficiently. For example, in his book, The Behavioral Investor, Daniel
Crosby describes one way that “anchoring” behavior works in everyday life: “When you meet someone new, you begin forming opinions of them within seconds. These first impressions, or anchors, then set the guardrails within which future impressions tend to fall.” As long as your assumptions hold true, they can speed things along next time you encounter the same individual. This also explains why we have the proverb, “You never get a second chance to make a first impression.” But in investing, people often anchor on the price they paid when deciding whether to sell or hold a security: “I paid $11/share for this stock and now it’s only worth $9/share. I’ll hold off selling it until I’ve broken even.” However, as the research behind evidence-based investing informs us, the best time to sell a holding is when it’s no longer serving your ideal portfolio as prescribed by your investment plans. What you paid is irrelevant to that decision, so anchoring on that arbitrary point creates a dangerous distraction.
Blind-Spot Bias. This concept is well-recorded in the famous poem by Robert Burns that ends with the lines, “O, would some power the giftie gie us / To see ourselves as others see us.” Blind spot bias occurs when you can objectively assess others’ behavioral biases, but you cannot recognize your own. This can actually be helpful in some cases, when it allows you to avoid over-analyzing your every imperfection so you can get on with your life. It helps you tell yourself, “I can do this,” even when others may have their doubts. In the fast-paced world of investing, however, it’s hard enough to root out all your deep-seated biases even after you’re aware of them, let alone the ones you remain blind to. In Thinking, Fast and Slow, Nobel laureate Daniel Kahneman says, “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are” (emphasis ours).
By the way, this is where second opinions from an independent advisor can come in especially handy. As fiduciary wealth managers, we are trained to help our clients identify and avoid these and other behavioral and emotional tendencies that can work against achievement of important long-term goals. If you are interested in how we might be able to put our expertise and independent judgment to work for you, please contact us.