The ABCs of Behavioral Bias: F-H

Let’s continue our alphabetic tour of common behavioral biases (See A-F here) that distract otherwise rational investors from making best choices about their wealth. Today, we’ll tackle F-H: fear, framing, greed and herd mentality.

 

Fear

 

What is it? You know what fear is, but it may be less obvious how it works. As Jason Zweig describes in “Your Money & Your Brain,” if your brain perceives a threat, it spews chemicals like corticosterone that “flood your body with fear signals before you are consciously aware of being afraid.” Some suggest this isn’t really “fear,” since you don’t have time to think before you act. Call it what you will, this bias can heavily influence your next moves – for better or worse.

 

When is it helpful? Of course there are times you probably should be afraid, with no time for studious reflection about a life-saving act. If you are reading this today, it strongly suggests you and your ancestors have made good use of these sorts of survival instincts many times over.

 

When is it harmful? Zweig and others have described how our brain reacts to a plummeting market in the same way it responds to a physical threat like a rattlesnake. While you may be well-served to leap before you look at a snake, doing the same with your investments can bite you. Also, our financial fears are often misplaced. We tend to overcompensate for more memorable risks (like a flash crash), while ignoring more subtle ones that can be just as harmful or much easier to prevent (like inflation, eroding your spending power over time).

 

Framing

 

What is it? Thinking, Fast and Slow,” Nobel laureate Daniel Kahneman defines the effects of framing as follows: “Different ways of presenting the same information often evoke different emotions.” For example, he explains how consumers tend to prefer cold cuts labeled “90% fat-free” over those labeled “10% fat.” By narrowly framing the information (fat-free = good, fat = bad; never mind the rest), we fail to consider all the facts as a whole.

 

When is it helpful? Have you ever faced an enormous project or goal that left you feeling overwhelmed? Framing helps us take on seemingly insurmountable challenges by focusing on one step at a time until, over time, the job is done. In this context, it can be a helpful assistant.

 

When is it harmful? To achieve your personal financial goals, you’ve got to do more than score isolated victories in the market; you’ve got to “win the war.” As UCLA’s Shlomo Benartzi describes in a Wall Street Journal piece, this demands strategic planning and unified portfolio management, with individual holdings considered within the greater context. Investors who instead succumb to narrow framing often end up falling off-course and incurring unnecessary costs by chasing or fleeing isolated investments.

 

Greed

 

What is it? Like fear, greed requires no formal introduction. In investing, the term usually refers to our tendency to (greedily) chase hot stocks, sectors or markets, hoping to score larger-than-life returns. In doing so, we ignore the oversized risks typically involved as well.

 

When is it helpful? In Oliver Stone’s Oscar-winning “Wall Street,” Gordon Gekko (based on the notorious real-life trader Ivan Boesky) makes a valid point … to a point: “[G]reed, for lack of a better word, is good. … Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.” In other words, there are times when a little greed – call it ambition – can inspire greater achievements.

 

When is it harmful? In our cut-throat markets (where you’re up against the Boeskys of the world), greed and fear become a two-sided coin that you flip at your own peril. Heads or tails, both are accompanied by chemical responses to stimuli we’re unaware of and have no control over. Overindulging in either extreme leads to unnecessary trading at inopportune times.

 

Herd Mentality

 

What is it? Mooove over, cows. You’ve got nothing on us humans, who instinctively recoil or rush headlong into excitement when we see others doing the same. “[T]he idea that people conform to the behavior of others is among the most accepted principles of psychology,” say Gary Belsky and Thomas Gilovich in “Why Smart People Make Big Money Mistakes.”

 

When is it helpful? If you’ve ever gone to a hot new restaurant, followed a fashion trend, or binged on a hit series, you’ve been influenced by herd mentality. “Mostly such conformity is a good thing, and it’s one of the reasons that societies are able to function,” say Belsky and Gilovich. It helps us create order out of chaos in traffic, legal and governmental systems alike.

 

When is it harmful? Whenever a piece of the market is on a hot run or in a cold plunge, herd mentality intensifies our greedy or fearful chain reaction to the random event that generated the excitement to begin with. Once the dust settles, those who have reacted to the near-term noise are usually the ones who end up overpaying for the “privilege” of chasing or fleeing temporary trends instead of staying the course toward their long-term goals. As Warren Buffett has famously said, “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”

Well said, Mr. Buffett!

 

We’ve got more behavioral biases to cover in upcoming installments, so stay tuned. Next, we’ll continue through the alphabet, introducing a few more of the most suspect financial behavioral biases.

To read about Behavioral Biases A-F click here

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

What Gives You Control?

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Which of the following do you have more control over?

  1. Timing the market’s ups and downs
  1. Staying Invested and Staying Disciplined

besttt

 

You missed 1 day out of over 11,000, so what?

Above is a graphic that shows how reacting to market conditions (and/or attempting to time the market’s ups and downs) would change your return as an investor.  This example uses the Performance in the S&P 500 between 1970-2015 (that’s over 11,000 market days).  The annualized compound  return for the entire period was 10.27%.  If you had missed the single best day in the market during that time, your annualized compound return would be 10.01%.  In dollar terms, if you had invested $1,000 at the beginning of the period and received 10.27% annual return, you would end with $89,678.  If you had missed the best single day you would have missed out on $9,308 because your end result would be $80,370.  As a long term investor, that is quite severe a penalty for missing one day –  out of 46 years.

Let’s go a step further and say you missed the best 25 days.  Your annualized compound return would be 6.87%; or $21,224  if you had invested $1,000 at the beginning of the period.  That is a difference of $68,454 because you missed 25 days out of over 11,000.

If You Are an Investor, Then Be an Investor.

As investors, we want to focus on things that we can control.  What is out of your control? Predicting the market’s ups and downs, and letting our emotions determine the timing or frequency of our investments.  What is in your control? Settling on an appropriate mix of investments, investing in them, and staying true to your original objectives – knowing that there will be ups and downs along the way.

 

So instead of answering our original question, we’ll let you be the judge!

 

 

 

Attribution and Disclaimer: Graphic in US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Performance data for January 1970–August 2008 provided by CRSP; performance data for September 2008–December 2015 provided by Bloomberg. S&P data provided by Standard & Poor’s Index Services Group. US bonds and bills data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Fear and Greed: Repeat Until Broke

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Behavior Gap

 

 

Emotion + Investment = A Recipe For Disaster

The constant stream of information, daily stock prices, and the inevitable crises that inundate the news, all serve as a non-stop invitation for our emotional forces to enter into our financial and investment related decisions.  The result can be seen in the above illustration by Carl Richards.

When the universal human emotions of fear and greed (excitement is another word) influence our investment decision making, it becomes all too easy for us to ignore the evidence that tells us that markets are volatile, and that attempting to time the market or identify mis-priced investments will likely lead to poor long-term results.

Your Goals + Your Actions = A Recipe for a Plan

Instead of allowing our behavior to sabotage our long term goals, focus on the the things that you can control over time. Save, invest, re-balance, delegate responsibility, manage costs, set goals, and enjoy life!

 

Image Attribution: Carl Richards, (c) Behavior Gap 2013

Your Complete Financial Life

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Your Complete Financial Life

What the World (News) Thinks Your Investments Are: The Center Of Your Lfe

Investing, and the performance of investments, is often what is thought of first when considering financial goals and financial independence. In this illustration by Carl Richards, from his Behavior Gap series, investments are put into perspective in comparison to ‘Your Complete Financial Life.’

What Your Finances Actually AreA Tool For Reaching Your Goals

It may be easy to focus on investments as the key to your financial future, but the reality is that it so much more; savings, spending, risk management, income tax planning, estate planning. What about financial values? Goals? Your personal interests? So many aspects of our lives have a financial component. Together, as a whole, they form our financial life. Investments are just one part.

 

Image Attribution: Carl Richards (c) 2013 Behavior Gap