Given my perception that the stock market is approaching overvaluation, I thought it would be a good time to review some of the weaknesses that we as humans struggle with when making financial decisions. Sociologists and psychologists have studied human behavior in financial markets and have come up with some interesting conclusions. When it comes to making financial decisions, we have many inherent blind spots that can hurt us.
One of these blind spots is something labeled RECENCY BIAS. This means that people give much more weight to what is recently going on than what has gone on in the past. Let’s apply this to the financial markets. The U.S. stock market was up 32% last year. People have already forgotten about 2008 when the market was down 38%. This bias convinces us that whatever the markets have been doing as of late will continue.This can cause people to be aggressive at the exact time when they should be cautious.
Another blind spot that causes people to make bad financial decisions is LOSS AVERSION BIAS. They did a study with monkeys where they gave the monkeys one apple. A subset of the monkeys got an additional apple for a period of time, but then it was taken away from them, leaving them with one apple. The monkeys that had an apple taken away demonstrated negative emotions more than the control group that was only given one apple. Humans are very similar in this respect. In fact, it has been demonstrated that losses are twice as painful as gains. Selling a stock at a loss is difficult for most people. Loss aversion bias makes it very hard for some people to face losses in their portfolio and sell when things have gone down.
Another phenomenon that hurts investors is called ANCHORING. This is the tendency to rely on one piece of information to the exclusion of other valid information. An example of this is judging a fund solely by its recent short-term performance. The investor is ignoring long-term performance, risk, their time frame, tax efficiency and a host of other issues that would be appropriate to consider when making a logical investment decision. Anchoring is also related to HINDSIGHT BIAS. People will look at things after-the-fact and believe that they can apply this knowledge to predicting the future. Most investors are familiar with the standard disclaimer, “Past performance is not indicative of future results.” However, this disclosure tends to stay in the fine print, both on paper and in investors’ minds, when it comes time to make important investment decisions.
Lastly, people struggle with OVERCONFIDENCE BIAS. This applies to all areas of our lives including our finances. They did a study and asked a sample of people if their driving skills were better than the average in the group. Ninety percent said yes. Mathematically only 50% can be better than average, but almost everyone in the room thought they had superior skills. Note that there is a fine line between confidence and overconfidence. Confidence is realistically trusting in your abilities, while overconfidence usually implies an overly optimistic assessment of your knowledge or control over a situation. Keep in mind that professional fund managers that have access to the best reports and expertise in the market and spend 24/7 looking at this information, still struggle at achieving market-beating returns.
The main point is to avoid trying to outsmart the markets and instead work to outsmart yourself. Be aware of your blind spots and have a plan in place and an advisor that can help you defend against these innate biases that harm you when it comes to managing your wealth.
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