How Your Mind Plays Tricks on You - Lessons From Behavioral Finance


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Behavioral finance uses psychological and social factors to study how
people make economic decisions. It was once thought that human beings
will over time take the most logical, rational approach when tackling
problems. As you might imagine, this is not always the case. In this paper,
we address three common issues that affect amateur and professional
investors alike and explain different ways these issues manifest themselves
in everyday life. We also offer some advice on how to mitigate the negative
outcomes when the mind plays tricks on you. Being self-aware of these
factors is a critical first step.

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How Your Mind Plays Tricks on You - Lessons From Behavioral Finance

  1. 1. How Your Mind Plays Tricks on YouLessons From Behavioral FinanceBy Baird Private Wealth ManagementThere is no doubt that the global economy is experiencing heightenedvolatility and uncertainty. How we make decisions in the face ofuncertainty can have long-lasting implications, especially those choicesheavily influenced by emotion. This is true for many decisions made inlife, but our focus is to address how biases and emotions impact financialdecision-making. For that we explore the field of behavioral finance.Behavioral finance uses psychological and social factors to study howpeople make economic decisions. It was once thought that human beingswill over time take the most logical, rational approach when tacklingproblems. As you might imagine, this is not always the case. In this paper,we address three common issues that affect amateur and professionalinvestors alike and explain different ways these issues manifest themselvesin everyday life. We also offer some advice on how to mitigate the negativeoutcomes when the mind plays tricks on you. Being self-aware of thesefactors is a critical first step.Issue No. 1: How We Process InformationIt is often said that we are living in the information age. With 24/7 news cyclesand handheld media devices, people have unparalleled access to information.The human brain is amazingly capable of processing mass amounts of informationand experiences, but it too has limitations. Over time, individuals havedeveloped familiar heuristics or “rules of thumb” that aid in the processingof complex or missing information. Of course, any time a shortcut is taken,the margin of error increases. Even though we may believe that we approachdecision-making in an objective, rational manner, the lens in which we viewevents is often tainted by heuristics.
  2. 2. Anchoring and Adjustment Confirmation Bias and Cognitive Dissonance A common strategy for estimating unknown information is to start with Our innate desire to be right and known information that serves as an avoid the embarrassment of being anchor or reference point, and then wrong skews how we seek or process make subsequent adjustments until information. This means seeking a more accurate value is obtained. evidence that supports a viewpoint Put simply, this is a crude system (confirmation bias) or rationalizing of trial and error, often taking place evidence that disproves a viewpoint subconsciously. The problem is that (cognitive dissonance). we are predisposed to outweigh known Why do people with left-wing or information (anchor) regardless of right-wing political views watch specific its accuracy or relevance, and any programs or channels for their news?“ et your facts first; then G adjustments are usually insufficient It is because they find it more pleasing distort them as you please.” in determining a precise result. to be exposed to information that – Author Mark Twain Think about whether you would they already believe. People may more actually pay the full sticker price on commonly recognize this behavior a car. Dealerships explicitly use that in the form of “selective hearing” reference point to make a final sale when a spouse or child only hears price more attractive. Just because what they want to hear – one form of something is on sale doesn’t mean it confirmation bias. On the other hand, is a good deal. Alternatively, wineries cognitive dissonance deals with denial, use prices as a signal of quality and avoidance and rationalization. sometimes list reserve wines at such a These biases can be harmful in investing high price that all other bottles appear if people become emotionally attached attractively priced. to an investment opportunity or lack The process of anchoring and the objectivity to process information adjustment is widespread in the rationally. There does appear to be less investment business. Examples include dissonance when a recommendation thinking that past performance has is made by another since there is now predictive qualities or basing valuations someone to blame other than yourself. on historical points such as 52-week The different responses to internally high/low price. versus externally generated ideas are something we see quite often. Tips and Advice Use various benchmarks or reference Tips and Advice points to better triangulate. Past Employ objective screens when performance should not set the selecting investments. For financial precedent for future outcomes. Try to and non-financial decisions, play understand why something is priced Devil’s Advocate with yourself, ask the way that it is – there is usually a disconfirming questions, and use a good reason. Realize that the margin trusted resource (including a Financial of error in any decision is often larger Advisor) as a sounding board. than you anticipate. -2-
  3. 3. Availability and Hindsight Bias Mental Accounting When processing information, the Mental accounting is the tendency mind tends to prioritize for ease of for people to separate their money dissemination and recollection. Not into ‘accounts’ based on subjective surprisingly, the newest information criteria, like source or intent, and act and most vivid “stories” are given higher differently with the money based on preference when it reconstructs memories. the account type. This is called the availability bias. For example, found money (tax returns, When purchasing a car are you more inheritance, bonuses, etc.) is often apt to purchase based on 1,000 treated differently than earned income, anonymous consumer reviews that with found money being spent more rate it highly or your neighbor, who frivolously. Another common mistake just purchased the car and it turned occurs when the financial transaction out to be a lemon? Most people weigh takes place well before the consumption the neighbor’s claims more heavily date. How many times have you despite it being a sample size of only actually used a coupon book sold by a one because it represents a more kid in the neighborhood raising money salient example. for school? Surprisingly, sites such as Groupon estimate that 20–30% of its How could anyone have missed that coupons go unused. This is because there was a bubble in the housing people tend to treat previous purchases market? Wasn’t that obvious? as a sunk cost and have already written Hindsight is 20/20 and revisionist it off in their mind. history is rampant when money is on the line, making people believe that Mental accounting impacts personal an outcome is more obvious once it is finances because people segment their“ he four most expensive words T already known. However, after-the-fact assets instead of taking a holistic view. in the English language are observations mask the uncertainty that Individuals must remember that a ‘This time it’s different’.” occurs in real-time market analysis. dollar is worth a dollar no matter – nvestor turned philanthropist I If someone would have acted on the where it came from. Sir John Templeton housing bubble, would they have foreseen the liquidity crisis and ensuing Tips and Advice recession? Perhaps not. Have your advisor create a financial plan that includes all of your assets and Tips and Advice make decisions based on the whole Keep accurate records of why an puzzle, not individual pieces. View all important financial decision was money the same and debt as negative made and refer to it in order to help money (plus interest) – focus on both prevent future mistakes. Don’t let sides of your personal balance sheet abnormal, one-off events or wishful when making decisions. thinking dictate your investment strategy. Remain focused on the Issue No. 2: The Role of Emotions long-term and don’t let daily market volatility or events drive emotions. Emotions are a powerful driver of decision-making – particularly feelings -3-
  4. 4. of satisfaction and regret – and can Let us work through an examplequickly turn a rational thought to highlight this point. Supposeprocess into an irrational one. you were presented with the twoInvesting – or any financial investment opportunities. Optiontransaction – has its highs and lows. A is a guaranteed payoff of $1,000A useful way to begin to understand and Option B has a 50/50 chance ofhow financial decisions are often earning $2,500 or $02. Numerousmade is to first recall what the studies have shown that the majorityprocess feels like. Buying a house select Option A, preferring theis a great example. Initially, there certainty of earning $1,000 despite itis great excitement when finding having inferior expected payoff relativethe perfect house for you and your to Option B ($1,250 or .5 × $2,500 +family. Apprehension sets in when .5 × $0). This is a classic example ofsigning reams of paper at the risk closing. From there, you Now let us turn the situation on itsexperience the joys and hardships head and talk about decisions thatof being a homeowner until it is time present losses. Now Option A is ato sell, at which point emotional and guaranteed loss of $1,000 and Optionfinancial ties to the home cause you B has a 50/50 chance of losing $2,500to value it very different from how or $0.2 In this situation Option A nowothers value it. has the superior expected outcomeWe dedicate this section to (i.e., losing less), yet studies haveexploring the psychological factors shown that individuals most likelythat cause investing to be a similar would choose Option B.emotional rollercoaster. This is the fascinating revelation ofProspect Theory Prospect Theory: when posed with expected gains, individuals are risk-At the core of behavioral finance is averse, but when posed with expectedhow investors feel about gains and losses, individuals actually becomelosses. The Prospect Theory purports risk-seeking.that people fear losing more thanthey value winning. This concept was Tips and Advicefirst empirically tested in the 1970s Try to spread out a gain as opposedby Nobel laureate professors Daniel to realizing the entire amountKahneman and Amos Tversky.1 immediately. When faced withThey quantified that the fear of losing potential losses, sometimesmoney is felt twice as much as the it is easier to take one large loss andjoy of winning money, meaning that move on than to prolong it into aindividuals are inherently loss-averse. series of smaller losses. Don’t becomeBefore these findings, it was assumed overly aggressive when trying tothat decisions were made rationally make up for market losses.based on the choice that presentedthe highest expected gain or lowestexpected loss. -4-
  5. 5. Disposition Effect Issue No. 3: Misdiagnosing Skill The Prospect Theory has clear and Luck implications for many decisions The next set of common mistakes is made in life because, at its core, it based on an investor’s perception of is about how one weighs risks and how skillful he or she is at predicting opportunities. It is therefore natural future outcomes. Egos are made and for people to want to recognize good broken on a daily basis in investing, feelings immediately and defer bad and these mistakes – namely ones. The theory also goes a long overconfidence – can be among the way in explaining the well-known most dangerous. tendency for investors to hold on to Overconfidence losing stocks too long and sell winning How many times have you heard stocks too quickly – known as the someone tell you that they are 99% disposition effect. sure about something? How many Investors often feel satisfaction when times were they incorrect? Probably their investments show a profit and more than 1%. Overconfidence in are quick to lock in those gains. behavioral finance doesn’t mean Conversely, the pain of feeling regret that everyone is a narcissist. What it will prompt many to hold on to a does state is that we tend to be too losing position in the hopes that it will confident in the accuracy of our own break even. The most comprehensive judgments, and believe we know the study on this subject examined more solutions to complicated problems. This than 10,000 brokerage accounts and inflated perception of skill can lead to confirmed that losing stocks are held suboptimal investment decisions. in a portfolio longer than winning Underlying most financial transactions stocks.3 Furthermore, over the is the belief that the outcome will be“ The most important thing to do subsequent 12 months after the sale, a positive one. If that isn’t true, the when you find yourself in a hole those sold for a gain had an average transaction would likely not be made. is to stop digging.” return that was twice as much as those We purchase securities that we believe – Investor Warren Buffett sold for a loss. Investors often cut will increase in value, and sell ones we short on great investments and hold believe will decrease. Unfortunately, hope for poor investments. we are not as adept at fortune telling as we think. Overconfidence can lead to Tips and Advice speculative investments. Studies have Use set criteria for purchasing or also shown that overconfident investors selling securities. Incorporate new trade more frequently and achieve information as it comes available below-market results. and regularly evaluate your decisions. Investment opportunities Tips and Advice rarely have infinite lives – there is Allow third-party experts to always a time to get in and get out. invest on your behalf in areas where Employ formal or informal stop loss you don’t have expertise. Be honest limits (when applicable). when attributing success and failure and set realistic expectations. -5-
  6. 6. Gambler’s Fallacy Herd Mentality The role of fate or chance in financial As we’ve already discussed, people situations is described as the Gambler’s respond most strongly to the newest Fallacy. It is predicated on the belief information, so their reactionary style that a streak will reverse or continue is not surprising. Add to that some based on a series of past events. The overconfidence or the fear of not most common example involves keeping up with the Joneses and it gambling. Think about a roulette leads to herd mentality. game that landed on red an amazing 11 consecutive times. The natural Groupthink – as it is alternatively tendency is to bet on black since it’s called – stems from the fact that people bound to land on it soon, yet in reality feel more comfortable making decisions the chances are always 50/50, regardless that they see other people making. of previous outcomes. Another casino This false sense of comfort can lead example explains the peculiar behavior to suboptimal outcomes. In everyday of someone rushing to a slot machine life, this is visible with fashion fads and after watching someone else dump an TV programming. More dangerous endless stream of coins thinking that examples of herd mentality are asset the machine is now “primed” for the price bubbles and crashes, including the next person. (Hint: slot machines are most recent housing crisis. programmed such that each pull is given an equal probability of winning.) The pressure to conform to social The concept seems easy enough to norms can be a strong influence on avoid, yet everyone seems to fall prey to decisions. It is one thing to fall victim“ skate to where the puck is going I it at one time or another. to a fashion faux pas, but quite another to be, not where it has been.” – In finance, the term Gambler’s Fallacy to put your wealth at risk because of the Hockey player Wayne Gretzky is most often replaced by reversion action of others. to the mean. The same mistake holds true with investments: people Tips and Advice often assume that outperforming Make decisions based on what is most or underperforming securities will suitable for your investment style somehow revert back to average (the and financial situation. Think like a mean) over time. While this does contrarian by asking what everyone happen, it is not guaranteed – some is missing instead of fearing that you investments are simply really good or really bad. are missing out. Do your homework before investing or use an advisor to investigate ideas on your behalf. Tips and Advice Try to separate chance from skill. In situations of chance, previous outcomes should have little bearing on your decisions. When viewing past performance, try to understand the drivers of those returns and whether outperformance can continue or underperformance will correct itself. -6-
  7. 7. Conclusions Behavioral finance – once thought of as an unconventional theory – is now a mainstream topic of academic exploration. It has broad relevance since it is not only tied to investing but also explains why many common household decisions are made. Some of the biases we have detailed have easy remedies. Others are much more difficult, but simply having a constant awareness of the bias is a step toward success. Financial Advisors can play a key role in this area. At Baird, we take a holistic view when providing recommendations to our clients. Planning for your future is as much about investment management as it is about risk management – and we are prepared to address both. “ rospect Theory: An Analysis of Decision under Risk.” Kahneman, Daniel and Tversky, Amos. March 1979.1 P2 Investment options indicated are hypothetical and used for illustrative purposes only. “ re Investors Reluctant to Realize Their Losses?” Odean, Terrance. December 1998. Journal of Finance.3 A ©2012 Robert W. Baird Co. Incorporated. Member SIPC. 800-RW-BAIRD. -7- MC-34247 First use: 1/12