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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.

Pattern Recognition

Is that a zebra, a cheetah or a light breeze moving through the grass? Since prehistoric times, evolution has conditioned our brains to find and interpret patterns.

From recognizing faces to decoding language, pattern recognition is a valuable part of everyday life. We see it in action when we stop for a red light and go when it turns green, and when we grasp why our spouse or partner gave us "that look." But false patterns can mislead us. Financial writer Jason Zweig has written about how simply presenting financial numbers in red instead of black can make investors more fearful and risk-averse. That's a powerful illustration of how pattern recognition can influence us – even if the so-called pattern (red = danger) is a red herring.

Think about the steady stream of breaking financial news that blares from airwaves every day. Is it a pattern, or just noise? We believe investors are well advised to discount the market's many glittering distractions and focus on their long-term goals.

Recency

Recency causes you to pay more attention to your latest experiences, and to downplay long-term factors. For example, in "Nudge," Nobel laureate Richard Thaler and co-author Cass Sunstein observe: "If floods have not occurred in the immediate past, people who live on floodplains are far less likely to purchase insurance." Recency bias tricks people into ascribing more importance to recent weather than to the reality of living on flood-prone terrain.

Giving weight to recent events is one way we update our ever-changing interpretation of the world we inhabit. But a long perspective matters too. Every bear market is full of investors who stumbled because they forgot the lessons of the previous correction. By reacting to the most recent jolts instead of remaining positioned as planned for long-term expected growth, they end up piling into high-priced hot holdings and locking in losses by selling low during the downturns. Investors who dwell on recent events risk taking their eye off the ball and undercutting their most rational, evidence-based investment decisions.

Sunk Cost Fallacy

The sunk cost fallacy is why many people will keep repairing an old car "one more time." If you've spent time, energy and money that can't be recovered, it can be harder to cut your losses and let go, even if you would be better off with a new car.

When a person, project or possession is truly worth it to you, sunk costs can help you take a deep breath and soldier on. But throwing good money after bad is not a recipe for successful investing.  The most rational investment strategy acknowledges we cannot control what already has happened to our investments; we can only position ourselves for future expected returns, according to the best evidence available to us at the time.

Tracking Error Regret

Tracking regret error is the "woulda, coulda, shoulda" bias – the envy you feel when you compare yourself to external standards and wish you'd done things differently.

Comparing yourself to a meaningful benchmark can be positive, spurring you to try harder.  For instance, a professional athlete who is in a slump might size up the competition and embrace a new fitness regimen, try some new equipment, or otherwise strive to improve their game. However, it can be damaging to your long-range plans if you compare your own performance to the general market, the latest popular trends, or your neighbor's seemingly greener financial grass.

If you've structured your investment portfolio to reflect your goals and risk tolerances, it's important to remember that your near-term results may sometimes march out of tune with "typical" returns. You're better off tending to your own fertile possibilities, guided by personalized planning, evidence-based investing, and accurate benchmark comparisons.

We've now reached the end of our alphabetic overview of the behavioral biases that most frequently lead investors astray. In a final installment, we'll wrap with a concluding summary.