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ABCs of Behavioral Biases: The Last Word

We began our series on the ABCs of Behavioral Biases by asserting an important point: Your own behavioral biases are often the greatest threat to your financial well-being.

We hope we've demonstrated the many ways this single statement can play out, and how often our survival-mode brains trick us into making financial calls that foil our own best interests.

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ABCs of Behavioral Biases: O to T

So many financial behavioral biases, so little time! We resume our series with our final batch of biases: overconfidence, pattern recognition, recency, sunk cost fallacy and tracking error regret.

Overconfidence

When we are pursuing a goal – whether it's fame or fortune, or just getting through our daily lives – we all have a very human tendency to overestimate our odds of success.

Overconfidence is generally beneficial, because it's what gives people the nerve to do hard things—such as asking for a raise or running a marathon. But it can be dangerous for investors. Combined with a host of other biases (such as greed, confirmation bias and familiarity bias), overconfidence fools us into thinking we can consistently beat the market by being smarter or luckier than average. In reality, it's best to be brutally realistic about how to patiently participate in the market's expected returns.

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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.