In our last post, we reviewed five of the most prevalent cognitive biases that trip up amateur and professional investors alike. This particular post is a continuation of that effort, and the third in a series of many behavioral finance posts.
When it comes to the world of behavioral finance, emotional biases can be the most crippling, as well as the most frustrating for advisors to see in their clients. Emotional biases generally involve taking action on feelings instead of fact, or making emotionally driven decisions rather than logical ones. What's interesting is that while a cognitive bias may result from having inaccurate or incomplete information, emotional decisions don't tend to be based on information at all, but rather are driven by intuition or impulse. Unfortunately, it's much more difficult to simply "educate them away;" rather, we must understand and adapt to them.
There is certainly some overlap between emotional and cognitive biases, but below, I present five emotional biases that you will want to be aware of, as well as some advice on how to appropriately modify your behavior and adapt to those biases.
1. Endowment Bias
Chances are you've seen the following plotline in a movie or TV show: hero has a prized possession with considerable sentimental value, possession is given away or donated to charity, hero must go out and rescue prized possession, frequently incurring great personal and financial cost in order to retrieve item. While the item may only fetch a few dollars at a thrift store, our hero is willing to pay hundreds to get it back. Obviously, this is a flawed and unrepresentative example, you say. Clearly, our hero is acting solely on the sentimental value!
Interestingly, this example is an extreme case of something that happens to nearly every object we buy. Far from being applied to prized possessions, we see objects as being worth more once we own them. This pattern - "the fact that people often demand much more to give up an object than they would be willing to pay to acquire it - is called the endowment effect," according to Richard Thaler (1980).
This is a key departure from standard economic theory's law of one price, that says a good must sell for the same price in all locations. According to classical economics, your willingness to accept payment and your willingness to pay should be roughly equal for the same item. However, that's frequently not the case in practice. Something about ownership makes us place a higher value on objects than standard economic theory would explain. This has been experimentally found to be true not just with prized possessions such as NCAA Final Four Tickets (Carmon and Ariely, 2000), but also with unsentimental goods such as chocolates and coffee mugs (Kahneman, Knetch, and Thaler 1990).
As an investor, this rears its ugly head with, you guessed it, investments that you have bought. People are resistant to selling securities that they already hold, even if they wouldn't necessarily re-buy them under current conditions. We also exhibit an inability to unload "bad" stocks (that's regret aversion; we'll get to that shortly!)
People are particularly reluctant to sell securities that they have inherited, either for reasons of disloyalty, or in some cases, taxes or transaction costs. This is a product of familiarity: You don't want to transition into something less familiar because then you feel you can't track it as well. It's hard to come up with a good alternative among many options when you already feel you have something adequate, if sub-optimal. In these cases, you feel the loss more heavily than you would the gain of a similar, newly acquired something. May have negative impacts on portfolio performance or diversification when the wrong investments are in your possession and you're too attached to get out.
How to fight this? Well, experience helps. A study of trading card dealers at an expo shows that while the overall pool exhibited endowment effects, offers and bits are statistically indistinguishable for experienced collectors - the law of one price is maintained among this more sophisticated audience.
For people under the impact of the endowment effect, it's good to ask the question whether you'd invest in this security again or whether you'd do something else if you had inherited, say cash. It's also good to bring the discussion of the security bought or inherited back to the goals at hand. For issues of familiarity, try buying a small amount of the alternative security, until you're more comfortable with its performance and characteristics; then consider moving more money into it.
2. Status Quo bias
Underpinning the endowment bias is often a fair degree of status quo bias, which speaks to our tendency to stick to what we already have, as opposed to experiencing change or the unknown. In the words of Michael Pompian, "The scientific principle of inertia bears a lot of intuitive similarity to status quo bias; it states that a body at rest shall remain at rest unless acted on by an outside force." What's more, as investors, we tend to take our current state as the baseline, and then don't want to deviate from it - any deviation is perceived as a loss.
Samuelson and Zeckhauser (1988) note that while economic puzzles often give alternative options, they frequently fail to consider the option of doing nothing at all. Yet the authors' experiments show that individuals disproportionately choose to do nothing in the real world. For example, their experiment involves telling participants that they have inherited a large sum of money from an uncle and that they have to choose one of four investment options to place it in. Alternatively, they tell participants that the uncle had previously selected one of those four options. As expected, that "status quo" portfolio was chosen far more frequently than when all four options were designated as equally new.
In practice, status quo bias keeps us from selling securities that underperform or are no longer appropriate for our goals, meaning that we can sometimes take excessive risks or invest too conservatively for our risk tolerance. We also use familiarity or fondness to justify holding onto things that exhibit poor performance, or don't sell for fear of incurring trading costs.
Unfortunately, Samuelson and Zeckhauser also found that after the experiment, when they talked about status quo bias with the participants, the participants were surprised to hear they fell prey to it. The authors note that, "even if the bias were recognized, there appear to be no obvious ways to avoid it beyond calling on the decision-maker to weigh all options even-handedly."
Weighing all options logically will likely not eliminate the emotional bias. However, there are a few things investors can try to mitigate the effects of status quo bias. First, attempt to quantify downside risk in understandable terms: that is to say, dollar amounts. To go a step further, link those implications with the lifestyle changes that may result as a result of continuing to hold the sub-optimal investment. In addition, for clients concerned about fees, position the trading costs in reference to the potential downside or opportunity cost of continuing to hold the investment. While traditional logic may be faulty, putting the decision in clear terms they understand may be helpful.
3. Regret aversion
In addition to the status quo bias, there is also a fair degree of regret aversion involved in the endowment effect, marked by the following thought process: "What if I sell this stock and then regret it later?" This represents another emotional bias known as regret aversion, which boils down to an avoidance of taking actions that may result in regret down the line. This bias can manifest itself in a number of ways: holding on to "losers" in order to avoid having sold at a loss, worrying about buying into markets that have recently exhibited losses, or even avoiding taking gains on a "winner" for fear of leaving money on the table if the stock price continues to rise.
According to Michael Pompian, "regret causes people to challenge past decisions and to question their beliefs," neither of which we as humans tend to particularly enjoy. When the outcomes of the decision are highly visible or accessible, as is the case with stock data, regret becomes even more influential.
What's interesting about this bias is that it tends to rear its ugly head at the very points we need to keep cool. Think for example about investors whose regret aversion kept them from putting money into the stock market in 2008 - and the many years of bull market they missed as a result! Likewise, think of all the high-flying stocks that tanked and left their investors with a fraction of the value. These are all perfect examples of spectacularly bad market timing that may result from trying to avoid negative feelings of regret.
In addition to bad market timing or missing out on gains, regret aversion can also cause a bias in favor of "trustworthy," or "good" companies. In other words, there is a sort of herd behavior that results from regret aversion. For example, given a popular stock and a less popular stock with the same expected return, a regret-averse investor would choose the more popular stock. That way, if the stock has a bad outcome, it's easy to default to "well, we were all wrong together," instead of "only fools would invest in what I chose!" Investing conservatively out of fear, however, can be highly detrimental to your portfolio, particularly for an investor with a long time horizon.
To identify regret aversion, start to catalogue how you felt after making investment decisions - when were you most likely to regret them? If you start to spot a trend, that will give you insights into how to act in the future. For instance, some people might be too scared to get back into the market, while more aggressive investors' loss aversion might take the form of holding winners for fear of missing out on excess return. Understanding your particular form of regret aversion may help you be more aware of your actions in the future.
Other important tips for dealing with this bias include setting price targets to take the emotion out of the buy or sell decision as well as making sure that each decision is well researched and consistent with you or your clients' long-term goals.
4. Self-Control Bias
And speaking of regrets, let's talk about self-control bias, the ability to override (or not) our urges, to consume today at the expense of tomorrow.
I personally am an expert in self-control bias. It's many a time when I've passed off tasks and projects to this mysterious being known as Future Michelle, who is, it seems, an all-powerful goddess. Unfortunately, by the time Future Michelle converges to Present Michelle, I find myself stuck in the very same behavioral traps. In other words, my plans to act better in the future rarely pan out. Obviously, I'm not the only one. The majority of people plan to act "better" in the future even if they're not making good choices today. But in the world of investing, this has particularly important - and dangerous - implications for things such as retirement saving.
In that regard, self-control bias may have less to do with how we invest our money, and more to do with whether we're saving it to invest in the first place. For the average consumer, the additional retirement money added each year is an important part of the savings game. It's easy to put this off knowing that there are bills to be paid today, competing financial interests, and shorter-term goals that need fulfilling. Self-control issues also crop up in terms of withholding taxes and spending wisely.
For the advisors who serve these clients, getting them to act in their own future interests can be a challenge. If clients don't save enough, they may find themselves taking on undue risk in later years to try and make up the shortfall, or worse, having to scale back their goals or retirement plans.
Daniel Kahneman would suggest that low self-control is due to a depleted System 2. As we run out of mental energy to maintain our self-control function, we revert to impulsive behaviors that maximize our current state at the expense of our future state - by overeating, overspending, etc.
Luckily, research implies that even having a plan to handle these circumstances can help. Lusardi's 2001 paper, "Explaining Why So Many People Do Not Save," notes that "savings levels depend significantly on whether a household has planned for retirement." This is certainly good news for advisors, who may find success with setting clear and actionable savings goals and then helping clients stick to it.
If you want to do one better for your clients, find ways to get them to save that don't necessarily rely on their self-control. Creating systems such as automatic savings transfers, savings increases over time, increases in proportion to raises, etc., are all good ways to ensure that your clients have enough money later. External discipline can be a great substitute for self-control (just ask my personal trainer).
Finally, teach clients and average investors about compounding. While a lot of them may understand the concept in theory, showing them their wealth potential in practice, quantifying the growth of their money under different scenarios over time, and getting them excited about how substantially their money will grow over three decades, can also be a highly effective tool.
Our final bias of the post is strongly linked to overconfidence and the illusion of control, which I discussed in my last post on cognitive biases. We as humans tend to believe that a situation will turn out better for us than what's usually expected. Happy couples don't anticipate divorce, students don't anticipate performing in the bottom half of the class, and traders don't anticipate being on the wrong side of the trade.
Kahneman calls this "both a blessing and a risk." On one hand, optimism can be a good thing because it leads you to keep trying, keep working at something in the hopes that it will turn out better down the line, and maintain persistence in the face of difficulties. On the other hand, optimism can be unrealistic, causing us to persistently engage in activities that aren't good for us, or in the investing world, good for our portfolios.
Similarly, Kahneman notes that "there are periods in which competition, among experts and among organizations, creates powerful forces that favor a collective blindness to risk and uncertainty." In other words, our cultural taste for optimism affects a wide swath of investors, such that our forecasts and news media value experts who don't acknowledge their ignorance. Unfortunately, it would seem that acting on pretended knowledge is better than admitting that you don't know what you're talking about.
Nofsinger's 2005 research corroborates this: "We argue that the general level of optimism/pessimism in society affects the emotions of most financial decision-makers at the same time. This creates biased financial decisions that are correlated across society."
In the investing world, this has a number of implications. We think we're all above-average investors, we all think we can beat the markets, and when it comes to decision-making, we tend to overweight good news because we like good news more. Optimism can also lead investors to make more bets on individual stocks, overestimate their odds at successful stock picking, or invest too much in their own company's stock.
While it is difficult to overcome optimism even with training, there are a couple of things you can do to keep it on your radar. First, know it, so that you can at least spot it in your clients, and have your colleagues spot it in you. In addition, don't study individual investments in isolation. A large part of investment analysis often centers around the investment itself: how it's performed in the past, what fundamental drivers exist going forward, and what unique or unusual details tip an investment in the right direction. However, keeping a comparative analysis perspective can help keep your own assessments realistic. Think of the investment as being part of a set of comparables, then ground your analysis in the average risk and return for that set.
So why is all this important if emotional biases are so hard to change? Well, if you're an advisor, you need to be aware of what you're dealing with. You can't change your clients' reactions, but you can anticipate them - or in some cases, build your book of business around the biases that you know you're particularly adept at handling. For investors, the exercise becomes less about eliminating emotional biases and more about becoming aware of when they're more likely to flare up, so you can pre-build decision processes that eliminate emotional input.
Ariely, Dan and Carmon, Ziv. "Focusing on the Forgone: How Value Can Appear So Different to Buyers and Sellers." Journal of Consumer Research Dec 2000, 27 (3) 360-370; DOI: 10.1086/317590
Kahneman, Daniel. "Thinking, Fast and Slow." New York: Farrar, Straus and Giroux, 2011. Print.
Kahneman, D., Knetsch, J., & Thaler, R. (1990). "Experimental Tests of the Endowment Effect and the Coase Theorem." Journal of Political Economy, 98(6), 1325-1348. Retrieved here.
List, John. "Does Market Experience Eliminate Market Anomalies?" The Quarterly Journal of Economics, February 2003. Retrieved here.
Lusardi, Annamaria, 2001. "Explaining Why So Many People Do Not Save." Working Papers 0001, Harris School of Public Policy Studies, University of Chicago. Retrieved here.
Pompian, Michael M. "Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases." Hoboken, NJ: Wiley, 2006. Print.
Samuelson, W. & Zeckhauser, R. J. "Status Quo Bias in Decision Making." Risk Uncertainty (1988) 1: 7. doi:10.1007/BF00055564.
Thaler, Richard. "Toward a Positive Theory of Consumer Choice." Journal of Economic Behavior & Organization 1.1 (1980): 39-60. Retrieved here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.