By Mark Lamoriello, AIF® | President, Chief Investment Officer | 03.28.2019
It’s hard to admit when we’re being irrational. It can be even harder when we don’t realize it.
We expect to be driven by emotional instincts when dealing with relationships, politics and other subjects that produce strong feelings. Personal finances might seem like an odd fit with this group, but it turns out that we are all heavily susceptible to behavioral biases that can produce poor financial decisions.
Traditional economic theory held that people make rational choices to maximize their personal financial outcomes. There’s an obvious logic to this theory, and it’s probably fair to say that most people believe their decisions will have this effect. But it’s just not true.
The Origins of Bad Behavior | Forty years ago, in March 1979, psychologists Daniel Kahneman and Amos Tversky published “Prospect Theory: An Analysis of Decision Under Risk.” This paper kick-started the behavioral economics discipline, which centers on the study of biases that undermine our rational decision-making ability.
Fine, we might think, but it’s probably still fair to assume that people look pretty rational taken together as a big group, right? Wrong.
We’re all familiar with the concept of market bubbles. These are the product of “irrational exuberance” as former Federal Reserve Chairman Alan Greenspan stated in the mid-90s. The momentum-driven trends that create bubbles are one of several persistent anomalies that result from widespread disregard for fundamental market conditions.
When Shortcuts Set You Back | Behavioral biases are essentially mental shortcuts; they may be helpful in some aspects of our lives or could have been helpful millennia ago when we lived in less-hospitable environments.
Loss aversion, one of the first biases identified by Kahneman and Tversky, demonstrates that we tend to prefer avoiding losses over equal-sized gains. Perhaps this hardwired preference is a product of the fact that people with more-cautious tendencies survived to pass on their genes.
We dug into several interesting behavioral biases that we think it’s important to understand, and hopefully attempt to counteract, through better knowledge.
Overconfidence | Typically, over confidence bias is explained as unawareness of the limited information on which we base our decisions. In short, we have too much confidence in decisions that are more off-the-cuff than exhaustively researched.
Those who’ve had considerable professional success may have a heightened risk of succumbing to this bias since a proven track record can embolden overconfidence. The antidote? Do thorough homework before making financial decisions and use realistic assumptions.
Anchoring | We tend to fixate on certain numbers. Maybe it’s a sales target, the price paid for a neighbor’s home, or a fair-value estimate for a stock. The problem is that we often refuse to move away from those reference levels when new information implies they’re no longer relevant. We anchor to our preconceived valuations.
The solution to anchoring is to conduct market analysis. The tools to determine selling prices for real estate are readily available, while financial-market valuations can be more complex. Nevertheless, periodically seek out new information and acknowledge significant developments that might impact reference levels.
Familiarity | Legendary investment manager Peter Lynch used to command anyone who would listen to “invest in what you know.” Familiarity bias arises from the tendency to concentrate investments in industries we understand and major companies with household names.
There is wisdom in parlaying a strong understanding of an industry into investments. But this can become risky when it overwhelms an investor’s portfolio and undermines the essential risk-reduction benefits that diversification provides. What if an unforeseen crisis happens to afflict the industry in question? What is the risk of tying investment success closely to our professional fortunes?
Emotions may not be the primary culprit in these biases, but there is a sentiment-before-verification aspect to their pitfalls. There’s also room for straightforward emotion-driven irrationality, like the plainly un-economic decisions we make to increase satisfaction.
Is it irrational to own two homes for personal use when we can only live in one at a time? Or keep an old expensive gas-guzzling car in the garage only to drive a couple hours per month?
We can only say that their benefits are not quantifiable in a traditional sense. But as long as they don’t derail our financial plans then we think they’re perfectly acceptable indulgences, within reason.
If you still have questions or concerns regarding this topic, reach out to our retirement plan team experts—we would be happy to help.