“Behavioral finance is not the study of how ‘other’ people behave. It is the study of how we all behave. It is not just a window onto the world; it is also a mirror onto ourselves.”
Adopting this mentality is easy to give lip service to, and more difficult to truly practice. No matter how many times I reread Thinking, Fast and Slow, it will be for naught unless I accept that it’s about “us” not “them”. I don’t think this mentality comes naturally to any of us. It’s something we must constantly remind ourselves to do.
In the spirit of this, “us not them” mentality, I asked some friends from FinTwit to gaze into the behavioral finance mirror, and answer the following question:
What do you consider to be your biggest behavioral bias (as it pertains to investing or personal finance) and how do you work to control it?
In no particular order, here are the terrific answers I received.
The temptation to swing for the fences. This is how my over-optimism manifests itself.
On rare occasions, I will buy in my personal “fun account” (its < 5% of my assets) some microcap speculation, or make some private angel investment. The explanation is the same that all casino junkies and gamblers have: On rare occasions they pay off, and even when they don’t its a huge adrenaline rush of ups and downs. Its exciting, and to this former trader who began his career on a discretionary trading desk, the rush is a mix of nostalgia and high is worth that small cost.
I know all of the statistical (im)probabilities of success; I understand intellectually why this is a waste of money. But over the course of a 25 year career, including my first 5 on a trading desk, I have regularly sought to hit that vein. All junkies are only temporarily clean, and the same is true for traders. (I am glad I have a healthy outlet rather than a problematic obsession).
The good news is, most of my real assets are in long term, staid vanilla and boring holdings. At my firm, we eat our own cooking — all of us are invested alongside our clients. Our money is in the 401ks and portfolios that are literally the identical models as our clients.
Having been a spendthrift for most of my late teens (hello store credit cards), I really only started investing in my early 20s and sensibly started off with saving a regular monthly amount into a UK pension scheme.
By my early 30s I was earning enough to have lump sums to invest and this was when I discovered my biggest behavioural bias.
I realised pretty quickly that I am that person who loves the thrill of investing – the anticipation of the ‘big win’. In reality I was gambling, not investing, but I didn’t have enough experience to realise it.
Gold was my weakness (as I think it can be for many investors). I finally realised that I was not in control of my emotions when investing when I sold a perfectly good, diversified holding to invest in the shares of a tiny South African gold mining company, as a result of receiving a ‘tip’ from a stockbroker I knew.
Even today, more than 20 years later, I can remember exactly how I felt. The eternity it seemed to take for the Compliance Officer of the firm I was working for to give the go ahead to make the trade; the FOMO I experienced in those few short hours, terrified the share price was going to rocket. It still makes my palms sweat to think about it.
Just a few short months later, the CEO of the mining company was shot and killed by a rival faction of some sort (I clearly picked a blue chip sort of company to invest in!) and overnight my shares were suddenly worthless. Fortunately, I could afford the loss, but I felt sick to my stomach at how stupid I’d been.
Not long after that experience I joined Bloomsbury and discovered evidence-based investing (when the student is ready, the teacher will appear ;o) and ever since my investments have been invested in exactly the same way as our clients’ – in low cost, pure asset class funds which are designed to capture market returns, with tilts to factors which the evidence has shown provide enhanced returns.
I automate the investment of cash I add to my portfolio and rebalance it just once a year – that’s it. I receive quarterly valuations but only ever open the one which gives me the value at the end of the year. The rest go straight in the shredder.
It hasn’t been hard to change my behaviour to invest in this way – once you have the evidence laid in front of you, and spend your working life examining whether that evidence still holds true I’d be a fool to ignore it.
I finally learned that, as Warren Buffett says, investing should be boring.
Overconfidence. That is not unique to me, or investors in general. Nor is my solution particularly unique. I have essentially stopped owning individual stocks and/or narrowly focused ETFs. The challenge with active investing is that you have to get two things right. The first is actually buy something that has the potential to go up, i.e. outperform. Second, you have to hang around until it does. Oftentimes the two don’t match up. Once you have cleared the deck of your portfolio of these types of positions it makes it much more difficult, but not impossible, to backtrack. One bias down, umpteen to go!
The behavioral bias I’d highlight is Confirmation Bias.
As someone who lives in a world of writing and sharing thoughts and ideas, it’s easy to get caught in confirmation bias, and only seeing information that confirms the views you’ve put so much time and effort into writing about.
I combat this by actively and deliberately following information sources that I know (or at least anticipate) I will disagree with, to FORCE myself to see the other side’s views. I also take a strong position on always trying to find/get data and delve deeper, rather than just trying to rely on intuition (and watching for articles that reinforce and confirm my intuition). In practice, this has led us to building out a growing Kitces Research team to do more data gathering and survey research, to ensure we’re really understanding what’s going on.
Of course, I’m still someone who sometimes puts forth some pretty strong views and positions on certain issues. But I’ve really taken to the framework of having “Strong Opinions, Weakly Held”.
I use a variety of techniques to try to mitigate my biases. I look at my account statements only twice a year, for example. Overall, using the scientific method, broadly construed, is the best antidote to bias of any flavor. However, because of bias blindness, I’m confident that I don’t know about (or the extent of) my most damaging biases. And that’s remarkably troubling.
Hindsight bias was my biggest hurdle to overcome.
Hindsight bias makes one part of our brain lie to another part without even realizing it. The way I conquered my internal liar was to write down all of my trades and why I did them. Once every few weeks I would read what I wrote in order to check myself. If I knew Amazon was going higher, why did I short it 5 times due to valuation concerns?
This is a fool proof system. I mean, it takes a real fool to think they knew what was going to happen when their own words prove otherwise.
I think my biggest behavioral biases stem from the sheer fact that I entered the industry right as the Great Financial Crisis was starting to unfold. Try as I might, it is difficult not to anchor to this type of experience and overweight in my head the likelihood of such events occurring again in the future.
How this has manifested itself in my own personal investing experience is twofold.
First, I haven’t been as aggressive as I should have in putting additional money to work during equity market corrections. That said, I max out my retirement savings every year and have no idea what the password is to my 401k site so I’m never tempted to check performance or tweak the allocation. My taxable investments is where I play the “woulda, coulda, shoulda” game a lot more. Fortunately, I have gotten better over the years about automating and dollar-cost-averaging into that part of my portfolio.
The second major impact the crisis has had is my overall asset allocation. I place a greater emphasis on uncorrelated, diversifying investments than I imagine most of my peers of a similar age do. While some of these exposures have acted as a drag on performance the last few years, I still remain a proponent of “diversifying your diversifiers” given how much of my career risk and equity in my company are tied to the stock market.
My biggest bias is how optimistic I am, generally speaking. It’s a personality trait, but I generally believe the world will not come to an end and that things will work themselves out. This probably helps more than it hurts as it pertains to investing.
But my wife is a little more practical and conservative with our personal finances than I would be if left to my own devices. I think working together with her evens my optimism out a lot and probably helps us make good decisions as a family.
I was in India recently and they asked me the same question. I said, “Look, in the presentation I just gave, every chart and example I used is from the U.S. stock market. Why? Why not the German Dax, or the Nikkei? Just because I happened to be born in America.” The year I was born there was about a 5% chance that a newborn would be born in America. I — and many others — took those tiny odds and used them as the overwhelming backbone of what we consider investing “history”. Home bias is a powerful thing. I don’t think I control it; I just admit I’m susceptible to it.
“What do you consider to be your biggest behavioral bias?” Being a human being.
“How do you work to control it?” Being a quant.
Overconfidence. I’d like to think I’m not arrogant, but I definitely have confidence in myself–I feel like I can accomplish anything I can set my mind to, and while that is good for most areas in my life, it could be a bad thing when it comes to investing, both personally and for my clients. I rely on the research I’ve done that supports being too confident and trying to do too much as an investor is a recipe for disaster. I remind myself that I don’t know more than other investors, and I probably know less, so sticking to an investment philosophy that has evidence behind it to support it allows me to be content with a boring diversified portfolio and spend time focusing on other areas that are more important–planning, behaviors, client experience, and time with my family.
For me, personally, I think loss aversion is my biggest behavioral bias. Having started my career only shortly before the financial crisis and then having experienced unemployment coupled with market loss of investments, it really had an impact on me early in my career. I tend to be more cautious with my own financial decisions and a more conservative investor for my age. I have to work hard to overcome this bias by just using my own training and approaching the subject rationally, as I would advise my clients to do.
Of course, I would be remiss if I did not include my own answer to this question:
My own biggest bias is overconfidence. When I began learning about behavioral finance, it was definitely more about being amused by other people’s “irrational behavior” than anything intelligent or introspective.
It seemed like behavioral finance was the key to outperformance: just look all the stupid stuff other people do! How could we not outperform them when they act that way?
This was incredibly naive. If reading a few books on behavioral finance were the key to outperformance, we’d all crush the market every year.
Realizing that behavioral biases manifest not due to stupidity but because of our humanity was a turning point for me. I attempt to remind myself of this point whenever I catch myself using behavioral finance as a window instead of a mirror. It’s a constant struggle, and I am far from perfect with it, but it helps deflate my ego.