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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.

Hindsight bias can help us assume a more comforting, upbeat outlook in life. It is hazardous to investors, though, because your best financial decisions come from realistic assessments of market risks and rewards. Hindsight bias is undesirable because it means you're assessing your decisions based on the outcome, not whether the process was sound or not. If a high-risk investment happens to outperform, but you conveniently forget how risky it truly was, you may load up on too much of it and not be so lucky moving forward.

On the flip side, you may too quickly abandon an underperforming holding, telling yourself it was a bad bet to begin with.

Loss Aversion

Loss aversion means that we often fear losing more than we crave winning. This can complicate the process of balancing risks and rewards. For instance, even when odds favor a big win, imagining a slight chance that you might go broke leads most people to decide it's just not worth the risk.

Loss aversion works in your favor when you buy home and auto insurance. The chances are very low that your house will burn to the ground, your car will be stolen, or an act of negligence will cost you your life's savings in court. But loss aversion reminds us that unlikely does not mean impossible, and that's it's prudent to protect against worst-case scenarios. However, it plays against you if you decide to sit in cash or bonds during bear markets, or just because a correction feels overdue. The evidence favors staying put, if not bulking up on stocks when they are "cheap." And yet, the potential for future loss can frighten us into abandoning our carefully planned course toward the likelihood of long-term returns.

Mental Accounting

If you've ever treated one dollar differently from another when assessing its worth, that's mental accounting at play. For example, if you assume inherited money must be more responsibly managed than money you've won in a raffle, you're engaging in mental accounting.

Nobel laureate Richard Thaler, who coined the term, has noted that mental accounting can help people keep track of "where their money is going, and to keep spending under control." But it can play against you if you let it undermine your rational investing. Say, for example, you're emotionally attached to a stock you inherited from a beloved aunt. You may be unwilling to unload it, even if reason dictates that you should. You've just mentally accounted your aunt's bequest into a place that detracts from rather than contributes to your best financial interests.

Outcome Bias

Sometimes, good or bad outcomes are the result of good or bad decisions; other times (such as when you try to forecast future market movements), it's just random luck. Outcome bias is when you mistake that luck as skill.

This may be one bias that is never really helpful in the long run. If you've just experienced good or bad luck rather than made a smart or dumb decision, when wouldn't you want to know the difference, so you can live and learn? Outcome bias makes it difficult to evaluate decisions properly, causing us to be overly critical of sound decisions if the results happen to disappoint. Conversely, it generates a "halo effect," assigning undeserved credit to risk takers who gambled and won.

You're now more than halfway through our alphabetic series of behavioral biases. Look for our next piece soon.