Behavioral Finance and Economics—Our Natural Biases
These days, it feels like we can all use a little boost. After being cooped up for so long, many individuals are re-examining just about everything. Many are questioning their decision making and could probably use a refresher on how to avoid certain pitfalls common to the human experience. Now seems like a good time for us to revisit some of the ways our brains tend to work against us. Knowing our inherent human biases may not protect us from murder hornets, locust swarms, or whatever else 2020 has to throw at us but at least it will allow us to be more aware of some of our natural limitations. With heightened awareness, we should, in theory, be able to put ourselves in a more advantageous position to make high-quality decisions.
Introduction to Behavioral Finance
The field of behavioral finance is much newer than the field of economics. It has gained a lot of traction in recent years, however, as Richard Thaler was awarded the Nobel Prize in Economics in 2017. Behavioral Finance shines a light on some of the drawbacks of economic theory, which is based in rationality and always acting in one’s self-interests. Let’s examine some of the most common ways our brains steer us away from making optimal decisions.
Common Cognitive Errors
Types of Errors
- There are two types of cognitive errors that we commit often and frequently. Those errors can be classified as belief preservation errors or information processing errors.
Belief preservation errors
- Confirmation bias refers to the tendency of individuals to seek evidence that supports what they believe to be true while dismissing any facts or circumstances to the contrary. This being an election year, I am sure we can all point to countless examples of confirmation bias in the political arena. Once we have formed a view, we embrace all of the information supporting the view and reject all of the information that casts doubt on the view. Confirmation bias helps explain why The Pew Center just found that 65% of Republicans and Republican-leaning independents say they trust Fox News for political and election news and 61% of Democrats and Democrat-leaning independents say they distrust Fox News for political news. And yes, you can more or less reverse those numbers when talking about any of the major news networks (deep sigh).
- Hindsight bias is one of the more commonly referred to biases and describes the tendency for individuals to perceive events that have already occurred as being more predictable than they actually were. People also refer to this as the “I-knew-it-all-along” phenomenon. I am sure we can all think of various instances of this bias in action. Some examples of hindsight bias would be:
- Everyone knew the financial system was going to come crashing down in 2008.
- It was easy to see the team was going to win the game after being down 25 points toward the end of the 3rd quarter.
- It was obvious to anyone looking that Jeff Skilling and Ken Lay from Enron were crooked businessman and conducting a complicated scandal that would result in Enron’s bankruptcy.
And the list goes on and on.
Unfortunately, we rarely “knew-it-all-along.” It is only with concrete knowledge of the past that we make these statements. One way to combat hindsight bias it to attach probabilities to events before they happen. You can then look back at your assessment after the fact with a clearer head and realize that having “knowledge of the future” is not really possible. It only happens after the fact.
The Illusion of Control
- Those who suffer from the illusion of control bias tend to have a difficult time accepting that not everything is within their control. This bias can be a bigger hindrance than many people realize. It is a very dangerous bias to suffer from as it leads the individual to expend a ton of time and effort in areas where they have little influence. Additionally, acknowledging and accepting areas where one has little to no control is not very easy for most people. Ultimately, we cannot control everything. Putting as much effort into an activity or endeavor as one can and taking all of the possible steps to ensure success is about as much as any one of us can do. At that point, it is typically healthy to take a step back and allow things to play out naturally versus obsessing about every detail and becoming frustrated and/or angry. I have found that asking the question, “what else can I do to get the desired result?” is often a good way to help find a solution and exhaust all of the constructive possibilities within one’s control.
Information Processing Errors
- If you’ve ever purchased a stock, had it decline and said to yourself, “I’m not selling this company until my returns are positive” you’ve experienced anchoring. Essentially, anchoring is when we too heavily weigh an initial piece of information and it influences our future decision making. Anchoring affects us all in numerous ways. Your employer can “anchor” you to your initial base salary. In negotiations, both parties often get “anchored” to the initial offer. For example, think of the last time you went through the car buying process. The initial price offered typically sets the standard for rest of the negotiation.
- If you are one of the many people that believe flying in an airplane is more dangerous than driving in a car, you are falling victim to the availability heuristic or availability bias. The availability bias is a mental shortcut that occurs when we think of information that is most readily available as opposed to the information that is most representative. For example, is it more dangerous to be a police officer or a logger? Most people would quickly say that being a police officer is much more dangerous. However, numerous statistics show that loggers are more likely to die on the job than cops.
Common Emotional Errors
- This is our tendency to fall in love with what we already have. In other words, we tend to overvalue things that we own. Adam Smith wrote, “Every man [and woman] …lives by exchanging, or becomes in some measure a merchant, and the society itself grows to be what is properly a commercial society.” That is a pretty heavy thought. Being that ownership is so central to our lives, it would greatly behoove all of us to make optimal decisions when it comes to issues of ownership. Unfortunately, we rarely do.
- The overconfidence bias refers to our propensity to be too sure of our judgements. That is, most of us have subjective confidence in our abilities and judgements that far outweighs the objective reality of those abilities and judgements. To put it in a more sobering light, we all basically think we are better than we actually are. As was written by Don Moore, Ph. D. in Psychology Today, “Overconfidence is the mother of all psychological biases…overconfidence is one of the largest and most ubiquitous of the many biases to which human judgment is vulnerable.” It is a good thing all of our readers are well above average and have perfectly calibrated confidence.
- The loss aversion bias refers to our predisposition to prefer avoiding losses versus acquiring gains that are similar in nature. Most studies show that our preference to avoid losses is about twice as strong as our desire to obtain gains. That is, losing $10 feels about as bad as finding $20 feels good. Loss aversion is essentially an expression of fear and probably accounts for why we tend to focus on setbacks more than progress. As Charles Darwin once said, “everyone feels blame more acutely than praise.”
- Regret aversion describes our tendency to try and minimize regret in our decision making at the expense of making the best choice. We often make decisions to minimize regret as opposed to maximize the outcome. Because risk-taking increases the maximum possible regret, this bias leads us down a path of less risk-taking and less optimal outcomes. Individuals with high levels of regret aversion tend to hesitate most at moments when behavior that they deem aggressive or risky is actually the optimal strategy.
We all want to do what is in our and our loved ones’ best interests as frequently as possible. However, because of natural cognitive biases that hamper our decision making, we do not always act accordingly. Knowing these natural shortcomings of the brain will give us each more awareness as to when our brains may be leading us astray. Being conscious of these weaknesses will not eliminate them from our daily lives but will put us in a better position to make successful choices more often. And during these crazy times, it feels like we can all use any help we can get!
By Charles Verruggio, Chief Investment Officer & Senior Financial Advisor