Despite everything we know about efficient capital markets and all the solid evidence available to guide our rational decisions … we’re still human. We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions – a brew of chemically generated instincts and emotions that spur us to leap long before we have time to look.
Rapid reflexes often serve us well. Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running without pause to think; his or her laughter elicits an instant outpouring of love (and oxytocin).
But in finance, where the coolest heads prevail, many of our base instincts cause more harm than good. If you don’t know they’re happening or don’t manage them when they do, your brain signals can trick you into believing you’re making entirely rational decisions when you are in fact being overpowered by ill-placed, “survival of the fittest” reactions.
Put another way by neurologist and financial theorist William J. Bernstein, MD, PhD, “Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.”
A few of the common behavioral biases that occur as a result of human nature are:
Behavioral Bias #1: Herd Mentality
Herd mentality is what happens to you when you see a market movement afoot and you conclude that you had best join the stampede. The herd may be hurtling toward what seems like a hot buying opportunity, such as a run on a stock or stock market sector. Or it may be fleeing a widely perceived risk, such as a country in economic turmoil. Either way, as we covered in our video “Evidence-Based Investing Insights: Part 1 – Market Pricing,” following the herd puts you on a dangerous path toward buying high, selling low and incurring unnecessary expenses en route.
Behavioral Bias #2: Recency
Even without a herd to speed your way, your long-term plans are at risk when you succumb to the tendency to give recent information greater weight than the long-term evidence warrants. From our video, “Evidence-Based Investing Insights: Part 3 – Return Factors” we know that stocks have historically delivered premium returns over bonds. And yet, whenever stock markets dip downward, we typically see recency at play, as droves of investors sell their stocks to seek “safe harbor” (or vice-versa when bull markets on a tear).
Behavioral Bias #3: Confirmation Bias
Confirmation bias is the tendency to favor evidence that supports our beliefs and gloss over that which refutes it. We’ll notice and watch news shows that support our belief structure; we’ll skip over those that would require us to radically change our views if we are proven wrong. Of all the behavioral biases on this and other lists, confirmation bias may be the greatest reason why the rigorous, peer-reviewed approach we described in “The Essence of Evidence-Based Investing” becomes so critical to objective decision-making. Without it, our minds want us to be right so badly, they will rig the game for us, but against our best interests as investors.
You can learn more about the human factor in investing but watching the fourth video in our series on Evidence-Based Investing. It is entitled “Evidence-Based Investing Insights: Part 4 – Behavior“. You can watch it by clicking here. As always, please feel free to email me if you have questions or comments.