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ABCs of Behavioral Biases: H to O

There are so many investment-impacting behavioral biases, we could probably identify at least one for nearly every letter in the alphabet. We continue with the most significant ones by looking at Hindsight, Loss Aversion, Mental Accounting and Outcome Bias.

Hindsight

Hindsight bias is the "I knew it all along" effect – the belief that our memory is correct when it is not. For example, say you expected a candidate to lose, but she ended up winning. When asked afterward how strongly you predicted the actual outcome, you're likely to recall giving it higher odds than you originally did. This is a very common bias.

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ABCs of Behavioral Biases: F to H

Welcome back to our alphabetic tour of common behavioral biases that distract otherwise rational investors from making best choices about their wealth. In this edition, we will tackle Fear, Framing, Greed and Herd Mentality.

Fear

You know what fear is, but it may be less obvious how it works. When your brain perceives a threat, it releases chemicals such as cortisol and adrenaline that flood the body with fear signals. Even before you are conscious of being afraid, your body experiences a fight-or-flight response. This response can heavily influence your next moves – for better or worse.

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ABCs of Behavioral Biases: A to F

Welcome back to our "ABCs of Behavioral Biases." Let's examine four self-inflicted biases that knock a number of investors off-course: anchoring, blind spot, confirmation and familiarity bias.

Anchoring Bias

Anchoring bias occurs when you fix on or "anchor" your decisions to a reference point, whether or not it's a valid one. An anchor point can be helpful when it is relevant and contributes to good decision-making. For example, if you've set a 10 pm curfew for your son or daughter and it's now 9:55 pm, your offspring would be wise to panic a bit, and hurry home.

When is it harmful? In investing, people often anchor on the price they paid when deciding whether to sell or hold a security: "I paid $11/share for this stock and now it's only worth $9/share. I'll hold off selling it until I break even." Evidence-based investing informs us, the best time to sell a holding is when it's no longer serving your ideal total portfolio, as prescribed by your investment plans. What you paid is irrelevant to that decision, so anchoring on that arbitrary point is distracting.

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The ABCs of Behavioral Biases

By now, you've probably heard that your behavioral biases can be the greatest threat to your financial well-being. As investors, we leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done.

Why do we have behavioral biases?

Most of the behavioral biases that influence your investment decisions come from myriad mental shortcuts we depend on to think more efficiently and act more effectively in our busy lives.

Usually (but not always!) these short-cuts work well for us. They can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we're simply trying to stay afloat in the rushing roar of deliberations and decisions we face every day.

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Market Correction

Written by Brian Puckett, CFP®, CPA/PFS, Attorney at Law.

If you enjoy good writing, we recommend all of Warren Buffett's annual Berkshire Hathaway shareholder letters, dating back to 1965. While financial reports are rarely the stuff from which dreams are made, Buffett's ability to crystallize investing wisdom is remarkable. His most recent letter, covering 2016, was no exception, including this powerful insight about market downturns: