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.
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.
Fear is, of course, very helpful when you are truly in danger. But while the anxiety aroused by a physical threat like a rattlesnake deserves a quick response, financial fears are often misplaced. We tend to overcompensate for memorable risks, such as a flash crash, while ignoring subtle ones that can be just as harmful or much easier to prevent, such as inflation's erosion of your spending power over time.
Framing occurs when you present the same information in different ways, often evoking different emotions, according to Nobel laureate Daniel Kahneman. For example, he explains how consumers tend to prefer cold cuts labeled "90% fat-free" over those labeled "10% fat." By narrowly framing the information (fat-free = good, fat = bad) we fail to consider all the facts as a whole.
Framing can help us take on seemingly insurmountable challenges by focusing on one step at a time until, over time, the job is done. In this context, it can be a helpful assistant. But to achieve your personal financial goals, you've got to do more than score isolated victories in the market; you've got to win the war. This requires strategic planning and unified portfolio management, with individual holdings considered within the greater context. Investors who succumb to narrow framing may fall off course and incur unnecessary costs by chasing or fleeing isolated investments.
Like fear, greed requires no formal introduction. We've all witnessed investors who chase hot stocks, sectors or markets, hoping to score larger-than-life returns. In doing so, they ignore the oversized risks typically involved as well.
There is a fine line between greed and ambition, which can inspire greater achievements. But in our cut-throat markets, greed and fear become a two-sided coin that you flip at your own peril. Heads or tails, both are accompanied by chemical responses to stimuli we're unaware of and have no control over. Overindulging in either extreme leads to unnecessary trading at inopportune times.
When it comes to the herd mentality, cows have nothing on us humans, who instinctively recoil or rush headlong into excitement when we see others doing the same.
Sometimes conformity is helpful, enabling us as a society to create order out of chaos in traffic, legal and governmental systems alike. However, whenever part the market is on a hot run or in a cold plunge, herd mentality intensifies our greedy or fearful chain reaction to the random event that generated the excitement to begin with. Once the dust settles, those who have reacted to the near-term noise are usually the ones who end up overpaying for chasing or fleeing temporary trends instead of staying the course toward their long-term goals.
We've got more behavioral biases to cover in upcoming installments, so stay tuned.