The NCAA basketball tournament concluded this week, and if you’re like most hoops fans, you spent much of the past month kicking yourself for some of the decisions you made when filling out your bracket. Before you toss away those brackets, though, it’s important realize that some of the emotional and cognitive biases that affect the way we make basketball picks in March also affect the way we make financial decisions every day.
BEHAVIORAL FINANCE SCOUTING REPORT
In every aspect of life, emotions and our personality play a huge role in how we make decisions—and finance is no exception. Drawing on psychology, sociology, and economics, behavioral finance is a growing field of study that looks to explain how individuals make financial decisions.
Over the past several decades, behavioral finance research has identified several tendencies that often get in the way of investors making good decisions.
Confirmation bias: Humans tend to seek out and rely on information that confirms what they previously believed or what they want to believe. The same reason that we’re more likely to read an article that picks our alma mater to make the Final Four is the same reason that we’re more likely to dismiss the opinion of an equity research analyst who is bearish on a stock that we just purchased. To combat confirmation bias, remind yourself to be as objective as possible when evaluating sources of information.
Hindsight bias: “Well of course No. 4 California was going to lose to No. 13 Hawaii. How could I have not seen that coming? The signs were there all along!” While this might seem like a silly comment to be making the morning after the game, a lot of similar comments were being made in 2009 after the housing crash. While hindsight is always 20/20, it’s important to remember that things that seemed obvious after-the-fact were anything but at the time when the decision had to be made.
Availability bias: Did you pick Stephen F. Austin to go to the Elite Eight because you saw the last five minutes of one of their games in February, and the Lumberjacks looked awesome for those five minutes? Well, then you understand the power of availability bias. In our financial lives, we tend to latch on to anecdotal pieces of information that are fresh in our minds. For example, when shopping for an insurance company, we might let our neighbor’s story about his one negative experience with the company outweigh hundreds of positive online reviews about the company’s customer service.
Disposition effect: When a team you picked won, you probably wanted to check the online bracket standings right away to see how much you moved up. But when your pick for national champion got knocked out in the second round, you probably didn’t feel like checking the standings. This is an example of the “disposition effect.” People like to recognize good feelings right away and put off recognizing bad feelings. In the world of investing, the disposition effect helps explain why investors are prone to sell winning stocks too soon and hang on to losing stocks too long.
Gambler’s fallacy: If an 80% free throw shooter has missed his last two foul shots, then the next one is bound to go in. Right? Not necessarily. The gambler’s fallacy is the mistaken belief that abnormal streaks are due to end or instantly revert to the mean. If a company’s quarterly earnings have missed analysts’ expectations each of the past three quarters, it doesn’t mean that the company is more likely to exceed expectations in the next quarter.
Prospect theory: While rationality suggests that the joy someone feels from winning $50 in their office bracket pool would be proportionate to the pain of losing $50 in the office pool, in reality it doesn’t work that way for most people. Research by professors Daniel Kahneman and Amos Tversky has found that the pain of losing money was roughly twice as great as the joy of winning money. This loss-aversion phenomenon shapes the way many investors view risk and reward.
Overconfidence: If you won last year’s bracket pool, was it the result of your basketball acumen or just plain luck? If you’re like most people, you tend to attribute your successes to skill and your failures to luck. While this approach might pay dividends in terms of our emotional health, it’s not helpful when it comes to our financial lives. It’s important not to fall into the overconfidence trap when assessing your knowledge about a specific financial topic.
Herd mentality: When seemingly every ESPN analyst—and all of your friends—are picking Michigan State to reach the Final Four, it must be a safe pick, right? Besides, you wouldn’t want to look foolish and miss out on the Spartans’ run. This herd mentality, or groupthink, is very common in investing, as well, and it contributes to market fluctuations—on both the upside and the downside—that go far beyond what is supported by the fundamental analysis.
Familiarity bias: If you live in the Chicago area, you might tend to pick Big Ten teams whose players, coaches, mascots, and colors you are familiar with over a West Coast team that you’ve never seen play. Familiarity bias affects investors as well. It may cause investors to allocate a disproportionate amount of their money to U.S.-based stocks or, even more dangerously, over-invest in their employer’s stock.
Pattern recognition: If you picked unranked Seton Hall (located in New Jersey) to win the championship because an East Coast team with blue uniforms won the championship in 2014 and 2015, you may have let pattern-seeking override other parts of your decision-making process. Humans are predisposed to search for patterns when sorting through large amounts of data. Unfortunately, this can lead us to over-rely on our ability to detect patterns. Investors need to be careful not to confuse a mere coincidence with a recurring pattern.
STRENGTHEN YOUR DECISION-MAKING GAME
In life and on the basketball court, it’s important to know your strengths and your weaknesses. While it’s impossible to completely eliminate the impact of emotions on your decision making, the better you understand what potential biases and misconceptions you might be prone to, the better-equipped you will be to reach your financial goals.
One of the best ways to manage and counteract these personal biases is to work with a trusted advisor who understands your long-term goals and your personality. At The Retirement Network, we work closely with our clients to provide objective advice for their retirement planning and other financial goals.