The last set of behavioral biases in our series!
What is it? No sooner do we recover from one debilitating bias, our brain can whipsaw us in an equally damaging but opposite direction. For example, we’ve already seen how fear on the one hand and greed on the other can knock investors off course either way. Similarly, overconfidence is the flip side of loss aversion. Once we’ve got something, we are averse to losing it, so we will overvalue it compared to its going rate. But when we are pursuing fame or fortune, or even going about our daily lives, we tend to be overconfident about our odds of success.
When is it helpful? In “Your Money & Your Brain,” Jason Zweig cites several sources that describe overconfidence in action and why it’s the norm rather than the exception in our lives. “How else could we ever get up the nerve to ask somebody out on a date, go on a job interview, or compete in a sport?” asks Zweig, and adds: “There is only one major group whose members do not consistently believe they are above average: people who are clinically depressed.”
When is it harmful? While overconfidence can be beneficial, it becomes dangerous when you’re investing. Interacting with a host of other biases (such as greed, confirmation bias, and familiarity bias) overconfidence 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 – potentially literally.
What is it? Is that a zebra, a cheetah, or a light breeze moving through the grass? Since prehistoric times when our ancestors depended on getting the right answer, right away, evolution has been conditioning our brains to find and interpret patterns – or else. 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 Zweig, as a result of our brain’s dopamine-induced “prediction addiction.”
When is it helpful? When we stop at red lights and go on green, we’re making excellent use of pattern recognition. Is your spouse or partner giving you “that look”? You know just what it means before they’ve said a single word. And whether you enjoy a good jigsaw puzzle, Sudoku, or Rubik’s Cube, you’re giving your pattern recognition skills a healthy workout.
When is it harmful? Speaking of seeing red, Zweig published a fascinating piece on how simply presenting financial numbers in red instead of black can make investors more fearful and risk-averse. That’s a powerful illustration of how pattern recognition can influence us – even if the so-called pattern (red = danger) is a red herring. Is any given stream of breaking financial news a predictive pattern worth pursuing, or is it a deceptive mirage? Given how hard it is to tell the difference until hindsight reveals the truth, investors are best off ignoring the market’s many glittering distractions and focusing instead on their long-term goals.
What is it? Recency causes you to pay more attention to your most recent experiences, and to downplay the significance of long-term conditions. For example, in “Nudge,” 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, tricking people into ascribing more importance to the lack of recent flooding than to the bigger context of being located on a flood plain.
When is it helpful? In “Stumbling on Happiness,” Daniel Gilbert describes how we humans employ recency to accurately interpret otherwise ambiguous situations. Say, for example, someone says to you, “Don’t run into the bank!” Whether you’re currently floating down a river or approaching a financial institution helps you quickly decide whether to paddle harder in the stream, or walk more slowly through the financial institution’s door.
When is it harmful? Buying high and selling low is exactly the opposite of investors’ actual aspirations. And yet, no matter how many times our capital markets have moved through their bear-and-bull cycles, recency 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 to get the better of them, and their most rational, evidence-based investment decisions.
Sunk Cost Fallacy
What is it? Sunk cost fallacy makes it harder for us to lose something when we also face losing the time, energy or money we’ve already put into it. In “Why Smart People Make Big Money Mistakes,” Gary Belsky and Thomas Gilovich describe: “[Sunk cost fallacy] is the primary reason most people would choose to risk traveling in a dangerous snowstorm if they had paid for a ticket to an important game or concert, while passing on the trip if they had been given the ticket for free.” You’re missing or attending the same event either way. But if a sunk cost is involved, it somehow makes it more difficult to let go, even if you would be better off without it.
When is it helpful? When a person, project, or possession is truly worth it to you, sunk costs – the blood, sweat, tears, and/or legal tender you’ve already poured into them – can help you take a deep breath and soldier on. Otherwise, let’s face it. There might be those days when you’d be tempted to help your kids pack their “run away from home” bags yourself.
When is it harmful? Falling for financial sunk cost fallacy is so common, there’s even a cliché for it: throwing good money after bad. There’s little harm done if the toss is a small one, such as attending a prepaid event you’d rather have skipped. But in investing, adopting a sunk cost mentality can prevent you from unloading an existing holding once it no longer belongs in your portfolio. For better or worse, you cannot go back in time and alter what you’ve already done with your investments. But you can (and should) keep your portfolio optimized for capturing future expected returns according to your own goals and the best evidence available to us today.
Tracking Error Regret
What is it? If you’ve ever decided the grass is greener on the other side, you’ve experienced tracking error regret – that gnawing envy you feel when you compare yourself to external standards, and wish you were more like them.
When is it helpful? If you’re comparing yourself to a meaningful benchmark, tracking error-regret can be a positive force, spurring you to try harder. Say, for example, you’re a professional athlete and you’ve been repeatedly losing to your peers. You may be prompted to embrace a new fitness regimen, rethink your equipment, or otherwise strive to improve your game.
When is it harmful? If you’ve structured your investment portfolio to reflect your goals and risk tolerances, it’s important to remember that your near-term results may frequently march out of tune with “typical” returns … by design. It can be deeply damaging to your long-range plans if you compare your own performance to irrelevant, apples-to-oranges benchmarks such as the general market, the latest popular trends, or your neighbor’s seemingly greener financial grass. Stop playing the shoulda, woulda, coulda game. Stop chasing past returns you wish you had received based on random outperformance others (whose goals differ from yours) may have enjoyed. You’re better off tending to your own fertile possibilities, guided by personalized planning, evidence-based investing, and accurate benchmark comparisons.
We’ve now reached the end of our alphabetic overview of the behavioral biases that most frequently lead investors astray. If any of these stand out to you in your financial life, be in touch!
Woodstone Financial, LLC is a fee-only financial advisor, specializing in retirement planning, comprehensive financial planning, and investment management firm located in Asheville, North Carolina. Contact us to learn more about our services.