There is a wide variation of the sophistication of investors. Some have been investing for their entire lives, maybe for a living; others choose not to, or see the learning curve as too large of a barrier to entry.
Regardless of the skill set, or how many acronyms are after one’s name, we are all susceptible to the same biases when it comes to investing. Behavioral finance looks at the psychological and emotional aspects of investors’ behavior in connection to how and when they actually trade.
The idea and mentality that one has the ability to successfully predict future market events through data gathering or analysis runs rampant throughout our industry – the most common side effect? Overconfidence bias. Consistent luck leads to this illusion of control that in turn, causes an uptick in investors risk taking and additional trading.
It is easy to look back at past events and remember predicting an event that transpired. This is more common when a trade was not executed – clients often will want to know why their advisors did not anticipate events that they knew were a sure thing.
Cognitive dissonance, a form of hindsight bias, is when an investor’s memory of past performance is far better than the actual results. This leads to the exaggeration of past gains, and minimizing or forgetting past losses.
Many investors have trouble objectively reviewing and analyzing new information. The investors “anchor” to the first information the review. We are often comfortable with our first impressions of data, especially when it is intuitive and matches our preconceived notions. This is most clearly seen when individuals buy securities that have fallen because they “must” get back up to that recent high.
This belief perseverance is why people are unlikely to change their views given new information. We are inherently resistant to change.
At least two effects appear to be at work. First, people are reluctant to search for evidence that contradicts their beliefs. Second, even if they find such evidence, they treat it with excessive skepticism.
- Barberis and Thaler (2002)
These physiological biases are constantly at work and ubiquitous throughout all aspects of the field. As financial advisors, it is our job to recognize when and how they are at work not only in our clients, but in ourselves. We must train ourselves to lead our clients through the valley of darkness, a place where the drivers of this mental warfare never sleeps.