Understanding investor behavior to make better retirement decisions.
You have recently retired and decided that now that you have more time you will use some of that time to manage your investments. In order to make more informed investment decisions, it is important to understand what guides our own individual decision making and be aware of the more common investor mistakes. Behavioral Finance studies the impact of personal bias on investors and how these biases affect investor decision making.
The mistakes investors make based on biases tend to fall into four general buckets: self-deception, information process, emotional, and social influence. Within these buckets, understanding eight common investor biases and how they might affect your own decision making will help you build a well-thought-out retirement plan.
Overconfidence – Just as it sounds, this bias is an egocentric assessment of our own individual skills. Many times, individuals will, in their mind’s eye, transfer the success that they have had in their chosen profession or field of study to their ability to manage and choose investments.
The Narrative Fallacy – We love a good story. With media all around us it is easy to get caught up in “a good story”. Many times, people will let a good story guide their investment decisions rather than relying on the underlying investment fundamentals. It is easy to get caught up in story, both good and bad, but it can lead to the inability to judge information objectively.
Framing Bias – Framing Bias is when we make decisions based on how the information is presented rather than the facts themselves. Like the Narrative Fallacy, we look for and get fed stories that interest us. It is important to recognize the source of the information and look for conflicting or confirming facts prior to making a final decision. Just like a good debater, it is important to understand both (all) sides of an argument prior to making a recommendation or final decision.
Anchoring Bias – Again, Anchoring Bias is a based on how we process information. This occurs when we hold onto one piece of information to make a decision. It could be the first piece of information we hear or the most strongly presented piece of information. We then use the information to initially decide or to continue to affirm a decision. When investing, we need to continually evaluate new information to confirm or refute our original reason for making an investment. Managing investments is a dynamic process and when we get caught up using a singular static piece of information it can lead to making poor investment decisions.
Confirmation Bias – This bias is when we go down the “information rabbit hole”. This is where investors tend to focus on facts that confirm their beliefs and ignore information that contradicts those beliefs. The manner and depth of information available from online media today helps lead us down the information rabbit hole. In order to overcome this bias we need to actively search for, and be open to, information that might contradict our original investment ideas.
Loss Aversion – Loss Aversion is the tendency for investors to make hasty decisions to avoid losses rather focusing on the fundamentals of their investment decisions and why they chose a particular investment in the first place. Investing and portfolio management is focused on managing risk, not necessarily avoiding risk. Opportunity for gains always comes with some level of risk. All too often we see investment professionals use this particular bias to “sell” investors guaranteed products and annuities. Unfortunately, these types of products tend to have high underlying fees. Just developing a modest understanding of investment and portfolio risk can help overcome the Loss Aversion bias and lead to better decision making.
Representative Bias – This bias occurs when the similarity of investments confuses investors as to the probability of outcomes. Thinking that because one company or investment had a good or bad outcome infers that the same outcome applies to all similar investments is Representative Bias. An especially difficult part of identifying this bias is that investment companies will tend to use this bias to promote similar investments. We are seeing this today with Cryptocurrencies even though there are currently over 2000 different cryptocurrencies. Developers of investment products know that Investors make decisions to invest based on the success of a similar investments and not necessarily the merits of that individual investment.
Herd Mentality – The Herd Mentality bias is the tendency to go along with the crowd and invest in what others are investing in. It is the tendency to rely more on emotion and instinct rather than on independent disciplined research. More often than not, following the herd (not the trend) can lead to individual investors either buying near tops or selling near bottoms.
Overcoming emotions and biases to stay invested for the long run is one of the most important principles of investing. To overcome biases, you will need to prepare a plan, and commit to a disciplined investment process. Overcoming biases requires focusing on a disciplined research-based approach rather than the emotional news-fed approach to decision making.
One of the benefits of working with a fee only fiduciary investment advisor is that they can help you walk through your decision-making process and help you plan, prepare, and execute a well thought out investment and retirement plan. After all, your family’s financial plan is too important to not make the most informed investment decisions.