Most versions of economic theory assume humans are rational beings who will make the best decisions given the facts of their current circumstances. Unfortunately, a theory is not reality. People commonly make financial decisions based on irrational and inefficient cognitive biases and other psychological factors that ultimately influence fluctuations in the public equity markets.
To help avoid falling victim to their traps, investors must first consider how and why these biases occur. Following are six tenets of behavioral finance that should be avoided at all costs.
Anchoring
Anchoring is a natural tendency to make assumptions or judgments based on points of reference that individuals already know, even if those details are irrelevant to the decision at hand. For example, an executive who stays at a specific hotel brand for business travel may rely on that reference point when selecting a hotel for a family vacation. In this case, anchoring makes perfect sense.
In the investment world, however, anchoring may not always be sensible. Consider the investor who owns stock in ABC Typewriter Company and continues to buy additional shares below their initial purchase price of $100. The investor expects the stock price to eventually revert to its original value, which, in this example, is the “anchor” on which the investor makes a purchase decision. The problem with this type of thinking is that it does not consider changes that may occur within the company or its industry. For example, with the invention of the personal computer, ABC’s stock may never again reach $100.
Mental Accounting
Mental accounting is the tendency to treat and value money differently based upon subjective criteria, such as how it was received, which can lead to irrational decision-making. For example, it is not uncommon for people to think of inheritances, gambling profits and tax refunds as “free money” they can use to treat themselves to pricey gifts that they otherwise would not purchase with the money they earn from their jobs. Not only does this line of thinking discount the fact that a tax refund is actually the return of an interest-free loan taxpayers give to the government, but it also has the potential to impede investors’ long-term investment goals.
Disposition Effect
While some investors will sell losing investments at a gain to lock in those profits, others will hold onto those investments with the hope they will recover enough to be sold at a gain at some point in the future. This tendency to hold losers and sell winners is called the disposition effect. To illustrate, consider an investor who sold Apple stock in the early 2000s to lock in an immediate profit without considering how the company may perform in the future. Today, that investor would likely regret their previous decision. Instead, decisions to hold, sell or buy an investment should regularly be assessed based on timely facts rather than an investor’s past experience of gains and losses.
Confirmation Bias and Cognitive Dissonance
Often, investors may be so set in their beliefs that they refuse to listen to opinions that contradict their own (cognitive dissonance), and they only pursue evidence that supports their views (confirmation bias). Both behaviors can negatively affect investment decisions. Such is the case with investors in ABC Typewriter Company, who enjoyed above-average returns during a 15-year period. As the company struggled against the competition of personal computers, its stock stumbled, leading many financial advisors to recommend investors sell their shares.
Familiarity Bias
As indicated in the hotel example above, many people make decisions based on past experiences. However, when this bias is applied to investments, they may miss significant wealth-building opportunities. For example, a U.S. investor whose portfolio is made up entirely of well-known domestic companies will forgo the potential returns they could yield in foreign and emerging markets, which make up more than half the world’s market capitalization. This lack of diversification also increases investors’ risk profile, making their portfolios more sensitive to U.S. market volatility.
About the Author: Shane Phillips, CFA, CAIA, CFP®, is a senior portfolio manager and financial advisor with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with PWA Securities, LLC. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or info@provwealth.com.
Provenance Wealth Advisors (PWA), 200 E. Las Olas Blvd., 19th Floor, Ft. Lauderdale, FL 33301 (954) 712-8888.
Shane Phillips, CFA, CAIA, CFP®, is a registered representative of and offers securities through PWA Securities, LLC, Member FINRA/SIPC.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Any opinions are those of the advisors of PWA and not necessarily those of PWA Securities, LLC. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of PWAS, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Prior to making any investment decision, please consult with your financial advisor about your individual situation.
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UPDATED on October 2, 2023