Behavioral Biases: What Makes Your Brain Trick?

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

In last month's blog, we discussed the deep-seated "fight or flight" instincts that that trick us into making significant money-management mistakes. Now let's take a look at a half-dozen of the behavioral biases that arise from our wiring, and how they can sabotage even the best-laid investment plans.

Behavioral Bias #1: Herd Mentality

Herd mentality is what happens to you when you see a market movement afoot and rush to join the stampede. The herd may be hurtling toward what seems like a hot buying opportunity, such as a "next big thing" stock. Or it may be fleeing a perceived risk, such as a country in economic turmoil. Either way, as we covered in "Ignoring the Siren Song of Daily Market Pricing," following the herd puts you on a dangerous path toward buying high, selling low and incurring unnecessary expenses.

Behavioral Bias #2: Recency

Your long-term plans are also at risk when you succumb to the tendency to give undue weight to recent information. In "What Drives Market Returns?" we learned that stocks have historically delivered premium returns over bonds. Whenever stock markets dip downward, though, we typically see recency bias at play, as droves of investors sell their stocks to seek "safe harbors." In a roaring bull market, they reverse course and buy.

Behavioral Bias #3: Confirmation Bias

Confirmation bias is the tendency to favor evidence that supports our beliefs over evidence that contradicts them. We watch news shows that support our belief structure; we skip over those that might challenge us to change our views. Of all the behavioral biases on this and other lists, confirmation bias may be the greatest reason why the rigorous decision-making approach we described in "The Essence of Evidence-Based Investing" is so critical. Without it, our minds will rig the game to support our beliefs—even when they lead to bad investment outcomes.

Behavioral Bias #4: Overconfidence

Garrison Keillor made overconfidence famous in his description of Lake Wobegon, "where all the women are strong, all the men are good looking, and all the children are above-average." Keillor's gentle jab actually reflects reams of data indicating that most people (especially men) believe that their acumen is above average. On a homespun radio show, overconfidence is quaint. In investing, it's dangerous. The truth is that investors cannot expect to consistently outsmart the collective wisdom of the market, especially after the costs involved.

Behavioral Bias #5: Loss Aversion

Research has shown that we are significantly more pained by the thought of losing wealth than we are excited by the prospect of gaining it. As Jason Zweig, author of Your Money and Your Brain, states, "Doing anything—or even thinking about doing anything—that could lead to an inescapable loss is extremely painful."

One way that loss aversion plays out is when investors prefer to sit in cash or bonds during bear markets—or even when a correction "seems" overdue. The evidence clearly demonstrates that you are likely to end up with higher long-term returns by at least staying put, if not bulking up on stocks after they have fallen & while they are "cheap." And yet, even the potential for future loss can be a more compelling emotional stimulus than the likelihood of long-term returns.

Behavioral Bias #6: Sunken Costs

We investors also have a terrible time admitting defeat. When we buy an investment and it sinks lower, we resist selling until it's at least back to what we paid. In a data-driven strategy (and life in general), the evidence is strong that this sort of sunken-cost logic leads people to throw good money after bad. By refusing to let go of losers (or even winners) that no longer suit your portfolio's purposes, an otherwise solid investment strategy can be undermined.

There are many more behavioral biases, as detailed in Zweig's and others' books on behavioral finance. We recommend that you take the time to learn more. Understanding our bias can help us become more confident investors—and they're likely to enhance other aspects of your life as well.