Financial Planning Insights from Behavioral Finance

Without the proper perspective you can be your own worst enemy when it comes to financial planning. Finance-related behavior is often influenced by emotional and psychological biases that are embedded in the human psyche, and without a good understanding of these biases you may not be able to prevent yourself from falling victim to them. Behavioral finance is a relatively new area of study that combines the fields of psychology and economics. While traditional economics holds that markets are efficient and investors behave rationally, behavioral economics recognizes that many investors make irrational decisions. Human nature is often contrary to successful investing, and you need to understand the psychological factors that cause irrational behavior in order to become a better investor.

Ever wonder why some investors never sell losing investments, even when no signs of improvement are evident? Loss aversion bias may be to blame. Research has shown that the possibility of loss is twice as powerful of a motivator as the possibility of a gain of equal magnitude. This type of emotional bias often causes investors to hold onto losing investments too long with the hope that they will eventually recover losses. The phenomenon is often referred to as “get-even-itis.” The effects of loss aversion bias can be catastrophic when investors hold onto the stock of companies that are in serious trouble. Selling losing investments so that assets can be repositioned in an investment with better prospects is often the best course of action, but loss aversion bias can cause people to hold losing stocks too long. The bias can also cause investors to focus too much on risk and not enough on reward when evaluating potential investments, since avoiding loss is a more powerful motivation than seeking gain. Stop loss strategies that reposition portfolios after investments have declined can be helpful in combating loss aversion bias; but investors need to avoid impulsively selling entire portfolios during periods of market turmoil because timing the market does not work in the long run.

Confirmation bias is another great example of irrational behavior that can damage portfolios and hurt returns. Do you know anyone that holds onto beliefs despite overwhelming evidence that they are not correct? If you do, then you may have observed confirmation bias in action. As humans, we are adept at convincing ourselves that our opinions are correct. The human mind is vulnerable to confirmation bias, which leads individuals to overvalue and actively seek out information that confirms existing beliefs while ignoring or underestimating the importance of evidence that contradicts beliefs. Confirmation bias can cause an investor to only pay attention to positive news about a particular stock, which can result in overly concentrated holdings and inadequate diversification. This can lead employees to hold too much of their employer’s stock as people naturally emphasize the positive aspects of the companies for which they work.¹ Another manifestation of this bias would be bearish investors that sell out of the stock market during times of crisis and miss out on subsequent rallies because signs of a recovery are ignored. Prudent investors realize that all available data must be reviewed and factored into beliefs. The best investors are often those that are quick to realize their mistakes and change their opinions.

Have you ever failed to take decisive action because you were worried about regretting your decision later? Research has shown that people feel worse about a negative outcome if it results from a decision as opposed to the same outcome that arises from doing nothing. As a result, it has been documented that errors of inaction are four times more likely to occur than errors of incorrect action.² This cognitive phenomenon is known as regret aversion bias, and can cause investors to be too apprehensive about taking positions in financial markets that have recently generated losses. Individuals fear the regret they would feel if downward trends continue after an investment is made, and can wind up avoiding stocks which have declined to prices that represent compelling value. In order to combat regret aversion bias, learn to avoid underestimating opportunity cost. The gains that you would forego by not participating in a successful investment should be an important part of risk/reward analysis when evaluating potential investments.

Without a good understanding of the cognitive and emotional biases that are embedded in the human psyche, investors cannot hope to overcome them. The aforementioned biases are only the tip of the iceberg in behavioral economics. If you think that you may be falling victim to biases that cause irrational behavior, you may want to consider working with a financial planner that has a good understanding of behavioral economics. If you are not careful, you could be your portfolio’s worst enemy.

¹ Michael Pompian, Behavioral Finance And Wealth Management (John Wiley & Sons, Inc., 2006), 187-215 
² Bruce I. Carlin and David Robinson. (2009). Fear and Loathing in Las Vegas: Evidence from Blackjack Tables. Judgement and Decision Making, 4:385-396.

FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif. He serves as Director of Public Relations for the Financial Planning Association of Los Angeles.