In a previous article I examined traditional and behavioral finance theories, and identified several biases that interfere with investors’ ability to make sound investment decisions. In this article we delve deeper into each of the biases, and explore simple, yet effective ways to overcome those biases. While there are a multitude of behavioral biases, this article will focus on three: mental accounting, anchoring, and overconfidence.
Mental Accounting – is the process whereby investors categorize their assets into separate mental “buckets”, and thus spend or allocate funds differently. Some examples: Susan receives a monetary gift for her birthday and uses it to go out for a gourmet dinner; Bill allocates his year-end bonus for Christmas presents; upon receiving his tax refund, Sam takes a vacation he hadn’t built in to his regular budget. Research corroborates these examples; people do tend to spend their tax refunds differently than they spend their normal wages. Interestingly, in the past several years surveys show that Americans are spending their tax refunds to pay down debt in an effort to deleverage their household balance sheets. When investors practice mental accounting such as those in the examples above, they tend to view and assess individual assets separately instead of as a part of a total portfolio.
Anchoring – is when an investor latches on to the first bit of information they receive and is unwilling to accept new information. Assume John purchased a home for $500,000 at the peak of the market and is now trying to sell his home in a depressed real estate market; he would be reluctant to list or sell his home for less than $500,000 because he is emotionally anchored to that ”value” for his home. When investors exhibit the anchoring bias, they are unwilling to accept new information that is contrary to their the view that his home is worth $500,000 when it fact it might be worth much less. The risk here is that because John is anchored to his price, he may not be able to sell his home in a timely manner, which in-turn may have detrimental affects on his finances and portfolio, not to mention the possibility that the home value could decrease even further.
Overconfidence – Investors who are overconfident overestimate their ability to analyze data. Suppose Jane made some money on Cisco stock, she would begin to believe that she has a keen ability to identify all upward trending technology stocks. As a result, Jane would begin to buy more and more technology stocks, and thus her portfolio would become less diversified – diversification is one of the cornerstones of a balanced portfolio. Additionally, investors who are overconfident tend to not only have more concentrated portfolios, but also trade more frequently because they have an illusion of control that they can sell or buy at the “right time”. Many investors who exhibited the overconfidence bias during the dot-com era and the subsequent real estate boom, found themselves to be overexposed when that sector had a sharp reversal, and as a result lost most of their assets and wealth.
As you have read, an investor’s emotions can have detrimental effects not only on his/her portfolio, but also on stress level. The good news is that there are ways to significantly reduce these effects. Here are five things you can do right now to avoid some common behavioral biases.
1. Stop watching the daily news. News networks draw ratings by evoking viewer emotions; TV is meant to incite not inform. Watching news every day causes investors to react emotionally, rather than analytically and strategically.
2. Don’t look at your portfolio everyday. Investors who check their portfolios every day tend to trade more frequently and take on more risk.
3. Don’t fall subject to the anchoring trap. Read contradictory news. Actively seek news stories that differ from your viewpoint, and give them equal weight.
4. When evaluating investments, don’t just look at the risk and return characteristics of that individual investment. Rather, analyze how that particular investment will impact your total portfolio, and determine whether it will enhance your total return, minimize risk, or both.
5. Lastly, work with a Fee-Only financial advisor to develop a sound financial plan that is specific to your needs. Remember that investing is a long term endeavor, so stick to that plan!
Behavioral finance is a relatively new field of study and academics are continuously researching new relationships between investor emotions and their finances. While financial experts have identified a multitude of investor biases, the three detailed above have the most acute consequences, and yet can be overcome when investors are willing to slightly change their habits.