Your Brain and Investing: Third in an Occasional Series
In this series of articles, we’re looking at 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. The previous article in the series offered brief profiles of two more such biases: anchoring bias and blind-spot bias.
This time around, let’s move a little farther through the “ABCs” of behavioral investing, starting with confirmation bias.
Confirmation Bias. This behavioral characteristic has its origins in the need we have as humans to be right, and our corresponding dislike of being wrong. This means that confirmation bias tricks us into being extra sympathetic to information that supports our beliefs and especially suspicious of and sometimes even blind to evidence that conflicts with what we already believe. When it’s working in our favor, confirmation bias helps us build on past insights to more readily resolve new, similar challenges. Imagine if you had to approach each new piece of information with no opinion, mulling over every new idea completely from scratch. While you’d be incredibly open-minded, you’d also be either excessively indecisive or so slow to make a decision that you’d end up doing nothing. But the downside of confirmation bias is that once we believe something—for example, that a particular investment is a good or bad idea, or that the market is about to tank or soar—we want to keep believing it. To remain convinced, we’ll tune out news that contradicts our beliefs and tune into that which favors them. We’ll discount facts that would change our mind, find false affirmation in random coincidences, and justify fallacies and mistaken assumptions that we would otherwise recognize as inappropriate. And the worst part is that we’ll do all this without even knowing it’s happening. Even stock analysts can be influenced by this bias, as shown by a recent study at the University of Iowa. In other words, no matter how much knowledge we may have, we still tend to pay more attention to information that confirms our prior beliefs—even if the information is wrong.
Familiarity bias. Familiarity bias, somewhat related to confirmation bias, is another mental shortcut we use that disposes us to more quickly trust (or more slowly reject) an object or idea that is familiar to us. Do you cheer for your home-town team? Speak more openly with friends than strangers? Favor a job applicant who (all else being equal) has been recommended by one of your best employees or someone else whose advice you have found helpful in the past? If you answered “yes” to any of these questions, you’re making good use of familiarity bias. But in the world of investing, sticking with what is best known and most familiar can cost you. For example, considerable evidence tells us that a broad, globally diversified portfolio best enables us to capture expected market returns while managing the risks involved. Yet studies like this PhD dissertation from Columbia University have shown that investors often instead overweight their allocations to familiar investments. The dissertation focused on employees of the former “Baby Bells,” or regional Bell operating companies (RBOCs), Southwestern Bell, Verizon, Ameritech, US West, etc. Current and former employees of the RBOCs, as well as consumers in the areas served by the companies, typically confined their investments to the stock of the RBOC they knew best. Similarly, many stock investors instinctively assume that stocks of US companies are safer or better than foreign investments, despite evidence to the contrary. In this way, familiarity bias tends to work against investors establishing broadly diversified portfolios that are designed to mitigate the effects of volatility in one particular area of the market. This also explains why investors who work for a company that offers a stock purchase plan tend to be more comfortable than they should be, bulking up on their employer’s stock.
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 become “Informed Investors,” please click here to read our white paper.