Common Investor Biases
Written by Andrew Roth, Operations Manager
Ask a gambler on a hot streak about the source of their success and you’ll probably hear “I just had a good feeling” whether they’re betting on dice, cards, or horses. Some of us may laugh at this response (particularly those of us who have lost more than we’ve ever won in a casino), but this type of response is not atypical. Being the imperfect creatures that we are, humans often attribute success to skill or intuition (a special hunch) as opposed to sheer luck. Anyone who has been successful would rather take credit for it, than attribute it to randomness.
This is one of a few cognitive biases that most of us are vulnerable to, particularly when it comes to financial matters. It’s important to be aware of these types of biases since they tend to drive behavior which, as we know, is one of the biggest determinates of long-term financial success.
The gambler example is what we often call self-attribution bias. People often use past success as an indicator of their own skill. This can provide misplaced confidence in their ability to make future decisions. Another bias that can often compound on top of self-attribution is the tendency to chase trends.
Human evolution has programmed us to seek out patterns to make sense of the world around us (fire will burn us, all animals with large claws should be avoided, etc.). This is one of the techniques the human brain has developed over thousands of years to enhance our ability to learn, and ultimately, to survive. People are quick to try to find trends that can drive future decisions. Both biases can be detrimental to investors because they provide a rationalization to deviate from plans.
Another evolutionary bias is our “fight or flight” response. Our brains are programmed to respond quickly to threats by either confronting them or fleeing. The primal portion of our brain responsible for this is called our amygdala—our “lizard brain”. Biologically this makes sense, but in the financial world “fight or flight” can be damaging. In times when we’re confronted with uncertainty, people may be overwhelmed by the sense that they must do something to respond. This often triggers damage because investors make short term decisions with long-term implications.
Hindsight bias often follows. As they say, “hindsight is 20/20”. It’s easy to evaluate events in the rearview mirror. People generally over-emphasize how easy it would have been to react to events after-the-fact and then develop an idealized picture of what the perfect response would have been. Monday morning quarterbacking of the past can affect how people react to events in real-time. This leads to using an unrealistic picture of the past to try to navigate current unknowns. When it comes to investing, hindsight bias can drive investors to take the wrong lessons away from history.
We’re all vulnerable to biases. It’s easy to explain because we’re wired that way! Even members of our team are vulnerable to letting biases cloud our judgement on personal decisions—that little voice in the back of our head from time to time. It’s also understandable that these tendencies are compounded with emotion—since money, and how it fits into your life, can be highly emotional.
So if you ever find yourself in a situation where you feel like your biases, as they relate to financial decisions, are kicking in, remember that the team at Lee Stoerzinger Wealth Management is here to help. Allow us to talk through some scenarios with you and provide an objective second opinion. That’s our job and we’re always happy to help.
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.