Philosopher Blaise Pascal expressed well the human condition when he wrote, “The heart has its reasons, which reason does not know.” In ways both funny and frustrating, you can probably recall times when your own decision-making left you wondering, “Why in the world did I do that?” It happens to all of us, and it certainly happens to all investors.
The many ways we tend to “misthink” has become quite a field of study, with researchers identifying as many as 200 “behavioral biases.” SMI published an article about five of them several years ago. This article looks at three more.
The hope is that by understanding these biases, we can be better equipped to spot a faulty thought process before we act on it.
Cognitive dissonance.
This is what happens when two contradictory ideas do battle in your brain, your behavior is out of sync with your beliefs, or your beliefs are at odds with reality. For example, it’s what some people feel when they look in the mirror and how they actually look smacks up against the image they have of themselves. More to the point of this article, it’s the tension you feel when the market tumbles and a strong desire to run for the exits is met by the teaching you’ve seen repeatedly in a certain newsletter to “Stay with your plan.”How to deal with the dissonance? The typical advice is to change one of the factors in conflict. For example, let’s say you begin day-trading. The dissonance you feel may be because you know that the Bible teaches a “steady plodding,” long-term approach to building wealth. Your behavior is out of sync with your beliefs. It can be resolved only by changing your approach to investing or by rejecting your biblical beliefs (which we know you wouldn’t do!).
Now, envision a different scenario. You’re 60 years old and have taken all of the wise investing steps that are within your control, including carefully calibrating your portfolio’s asset allocation to your risk tolerance and time frame. Then the market rockets higher, and it keeps moving higher. Thoughts come to mind that maybe you’re playing things too safe and you should invest more in stocks. In that situation, the best response is to remind yourself that your asset allocation was chosen for all the right reasons and to reject any thoughts of reaching for higher returns.
Of course, that’s easier said than done. In many cases, the dissonance you experience may never get fully resolved. It’s a matter of learning to live in the tension and doing the right thing despite occasional doubts. This is one of the most important and difficult parts of successful investing.
The illusion of control.
With this bias, you may overstate your ability to influence an outcome that’s outside of your control. In a rising market, the illusion of control may tempt you to pat yourself on the back for being such a skilled investor. It may lead you to take on more risk than you should. Because of this bias, one of the worst things that can happen to someone who invests based on a hunch or a hot tip is early success. That can magnify feelings of skill when it was just luck.In a declining market, the illusion of control might cause you to take too much blame for your shrinking portfolio. That could leave you feeling discouraged and may even tempt you to stop investing.
The key is to take the steps you can control (invest enough each month, tune your portfolio to your optimal asset allocation, follow an objective, rules-based strategy) and then remind yourself that the market has its reasons, which, oftentimes, reason does not know.
It’s important for investors to remember that many factors are outside of their control. In the short-term, the market is often full of surprises. But fortune favors long-term investors who stay humble and take the wise steps that are within their control.
The endowment effect.
With this bias, people place a higher value on something they own than on the same item if they did not own it. It is tied to one of the most well-known cognitive biases, loss aversion. Because people feel loss more strongly than gain, they are often reluctant to give up something they already own. It is reflected in the saying, “A bird in the hand is worth two in the bush.”For investors, the endowment effect can make it difficult to sell an investment. Having an emotional attachment to the investment can make selling even more difficult. For example, people who inherit shares of stock from deceased relatives may resist selling those shares, even if they do not fit with their risk tolerance or investment goals. The same force is at work when you resist parting with an investment that you’ve held for a long time and that has done very well. Objective factors may signal that the investment has run its course, but the idea of selling can feel like discarding a faithful old friend.
Banishing the bias
Here are three ways for investors to lessen the influence of behavioral biases. First, follow an objective, rules-based investment strategy, such as those offered by SMI. When you follow a strategy with clear, unbiased buy and sell instructions, it is much easier to execute those trades than if you’re following your intuition or the headline of the day.
Second, have a written investment plan. At a time of market calm, commit to paper (or pixels) how you’re investing and why. Be sure to include a statement as to what you’ll do or not do during inevitable periods of market stress. Then, whenever you find yourself thinking about making a change, reread your plan.
Third, diversify your investments. Diversification is an approach promoted in Scripture (Ecclesiastes 11:2) and is an inherently humble approach to investing. To diversify is to acknowledge that no one knows for certain which investments will do better than others and it improves your odds of success. If you are properly diversified, when one part of your portfolio is declining, another is likely to be growing.
The goal is not to eliminate your emotions, were that even possible. The goal is to do what you can to keep your emotions from leading you astray.
