As physicians, we are trained to tease out biases in medical research to avoid faulty conclusions. We watch for them in our clinical interactions with challenging patients so as not to be led toward a missed diagnosis or inappropriate treatment. But how often do we recognize biases when it comes to our finances and personal investing?
Modern Portfolio Theory, the foundational theory of investment portfolio construction, relies on important assumptions about investors: they are risk averse, always make rational decisions, have full and equal access to investment information, and have an unbiased view of the future. An emerging field called behavioral finance pokes holes in all those assumptions and contends that investors bring all their biases to the table when making investing decisions, and many of those decisions are irrational and not in their best interest. In other words, they are humans being humans. Understanding how these natural biases affect our investment decisions may save you a lot of money and could even allow you to capitalize on others’ mistakes. Here are a handful of common biases to watch for:
There is an adage on Wall Street to not confuse brains with a bull market. When things are going well in the market and all your investments are making money, it is easy to become overconfident in your own ability as a stock-picker. Truthfully, it isn’t hard to find winning stocks when the market is rising. But when the market inevitably swings bearish, an overconfident investor can make decisions that end up costing them money.
Overconfidence in investing means placing too much value on your own knowledge, underestimating risk, and exaggerating your own ability to control events and predict outcomes. Overconfidence is driven by several factors, the first being access to information without the background to effectively filter it (i.e., you know just enough to be dangerous.) It is easy to fall prey to internet-based investment “advisors” who have various levels of expertise and motivations that may not serve your best interests.
A second factor is active involvement in the process leading to a false sense of control over the outcomes. In the online trading era, we no longer rely as much on brokers to advise us and execute our trades. We can easily do it ourselves with a few clicks of the mouse, which may result in a much higher frequency of trading than is advisable. A third factor is recent successes. Especially in bull markets, your success may have been entirely based on general market conditions and not your stock picking acumen at all. But recent wins drive you to trade more without considering actual values, and can lead to significant losses when the market inevitably takes a downturn.
The Disposition Effect
As humans, we naturally seek the positive reinforcement of a decision that turns out well and avoid the pain of those that turn out poorly. This is referred to as the disposition effect. Many studies have shown that the emotional pain from regret is much stronger than the joy from success (prospect theory), i.e., we experience more pain from losing 10 dollars than joy from finding 20 dollars.
In investing, this is demonstrated when we quickly sell our winning investments and hold on to our losers. A quick sell after a jump in value gratifies our pride and lets us pat ourselves on the back for a winning trade. But when our investments lose value, we hold onto them far too long to avoid the pain of locking in the loss. However, studies have shown that winning stocks tend to outperform the market over the next year, and losers continue to underperform the market. So, gratifying our pride by selling our winners and appeasing our regret by holding our losers is costing us money.
When making online purchases, have you noticed that if you really want the item, you are more likely to read the five-star reviews? Alternatively, if you are skeptical about the item from the onset, you read the one-stars? This is called confirmation bias, and it happens in investing as well. You seek out the information that confirms your opinion instead of looking for alternative points of view. A related idea is that of cognitive dissonance, which is when we only remember things in a positive light about our past performances. We forget about the losses and only remember the successes, leading to a warped view of our investing acumen.
In our minds, the value of an investment is what we paid for it, and we become emotionally anchored to that price. If the stock price drops, we wait until it gets back to that anchor point before we consider selling it. But what if we overpaid for the stock in the first place, and the lower price is the more accurate valuation? Hanging on to the stock in the situation may not be the wisest choice.
Past results are not necessarily predictive of future performance, right? It is a common financial advisor refrain. But it is easy to not invest that way. If stocks have been rising, we believe that they will continue to rise, and we buy. If stocks have been falling, we lose faith in the market and sell. This leads us to buy high and sell low: a sure recipe for disaster.
But there are strategies to overcome these investing biases.
- Understand the biases. The important first step in avoiding biases is to recognize that we are all susceptible. Catching ourselves early will help us to redirect.
- Know why you are investing. Have clearly defined time-anchored goals based on your risk-return tolerance. Your investing strategies should be different if you need the money in five years compared to 20 years. Remember, successful investing is a long game.
- Have quantitative investment criteria. Learn how to value a company with quantitative data that does not overly rely on opinion, rumors, or other psychological-based trends. Stick to your method and try to remove the emotion.
- Diversify. Own at least 20-30 different stocks in different industries with different market capitalization categories. This diversification is easily accomplished with low-cost index funds or ETFs if you do not want to research individual stocks. Do not hold large concentrations in any individual company’s stock (especially the company you work for.) Adding some bonds or bond funds will decrease volatility. Adding some international funds may level out US-based market fluctuations.
- Control your investing environment. Avoid becoming obsessed with daily stock price moves which can lead to overreacting to the news cycle and frequent trading. It is better to check your stocks less often, to make your trades and portfolio adjustments on a preset regular schedule. Review your portfolio annually to ensure that it lines up with your current goals and then adjust as needed. Remember, investing is for the long haul and should not be viewed as a quick money-maker.
- Mental Reminders. Remind yourself frequently of your financial goals and stick with your plan. These can be short-term goals like saving an extra $500 a month for a new car that you want to purchase, or long-term goals like maximizing your 401k for your retirement. These reminders will help you keep your eyes on the prize and not allow yourself to succumb to your emotions and biases.
Bryan Jepson, MD is an emergency physician and financial advisor. He works for Targeted Wealth Solutions, LLC, an independent advisory firm with a focus on financial planning and business strategy for medical professionals. www.targetedwealthsolutions.com.
Animation by Jennifer Bogartz