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 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.
Blind spot Bias
Blind spot bias occurs when you can objectively assess others' behavioral biases, but you cannot recognize your own. Blind spot bias can help you avoid over-analyzing your imperfections. It helps you tell yourself, "I can do this," even when others may have their doubts.
When is it harmful? It's difficult to root out all your biases once you're aware of them, let alone the ones you remain blind to. In "Thinking, Fast and Slow," Nobel laureate Daniel Kahneman describes (emphasis ours): "We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are." (Hint: This is where second opinions from an independent advisor can come in handy.)
We humans love to be right and hate to be wrong. This manifests as confirmation bias, which tricks us into being extra sympathetic to information that supports our beliefs and suspicious of or even blind to conflicting evidence. When it's working in our favor, confirmation bias helps us build on past insights to more readily resolve new, similar challenges.
When is it harmful? Once we believe something – such as an investment is a good/bad idea, or a market is about to tank or soar – we want to keep believing it. To remain convinced, we'll tune out news that contradicts our beliefs and tune into that which favors them. We'll discount facts that would change our mind, find false affirmation in random coincidences, and justify fallacies and mistaken assumptions that we would otherwise recognize as inappropriate. And we'll do all this without even knowing it's happening. Even stock analysts may be influenced by this bias.
Familiarity bias is another mental shortcut we use to more quickly trust (or more slowly reject) an object that is familiar to us. If you cheer for your home-town team, speak more openly with friends than strangers, or favor a job applicant who has been recommended by one of your best employees, you're making good use of familiarity bias.
When is it harmful? Considerable evidence tells us that a broad, globally diversified approach best enables us to capture expected market returns while managing the risks involved. Yet studies like this one have shown investors often instead overweight their allocations to familiar vs. foreign investments. We instinctively assume familiar holdings are safer or better, even though, clearly, we can't all be correct at once. We also tend to be more comfortable than we should be bulking up on company stock in our retirement plan.
Ready to learn more? Next, we'll continue through the alphabet, introducing a few more of the most suspect financial behavioral biases.