What are some of the behavioral tendencies we all can run into that affect our decision-making, and ultimately cause some big mistakes? What do big areas or behavioral tendencies look like?
In this episode of the Finance for Physicians Podcast, Daniel Wrenne talks about investing behaviors that will wreck your financial plan. Knowledge and awareness are needed to avoid behavioral finance mistakes.
- What is behavioral finance? When people make errors, mistakes, and biases
- Why? People are not rational or self-controlled and don’t identify tendencies
- Overconfidence: Common idea that you know more than you actually do
- Self-serving Bias: Attribute good things/outcomes to skill, bad outcomes to luck
- Hindsight Bias: You know more or knew more than you really did in the past
- Confirmation Bias: Focus on what confirms beliefs, ignore what contradicts them
- Recency Bias: Hone in on short-term and overemphasizes that importance
- Refer to your financial plan and remind yourself of your financial goals
- Anchoring Bias: Relying and latching onto too much pre-existing info
- Loss Aversion: Overly fearful of losses and pull to avoid losses
- Herd Mentality: Suffer from fear of missing out (FOMO)?
Full Episode Transcript:
Hey, guys. Hope you’re having a great day. I am excited to talk about investing, and this is the third in our series of three shows, talking investing. In the first, we talked a little bit more about how to navigate scary downturns in the market. The second, we talked more about how those looked historically, some of the numbers, returns and that kind of thing.
Today, we’re going to be talking about some of the behavioral tendencies we all can run into that can really affect our decision-making, and ultimately can cause some big mistakes. We’re going to get into that today.
This is a big topic, behavioral finance is what they call it. Behavioral finance is a monster topic. It’s one of my favorites to get into. Today, we’re just going to hit some of the high points of some of these behavioral tendencies that are out there, and hopefully give you some baseline knowledge and awareness so you can start to see them and other people and yourself, and ideally avoid some of the mistakes that can come into play as a result of them. So we’ll jump into that now.
We’re talking behavioral finance. This is a fun topic. It’s one of those things. It’s a little easier (probably) to identify it in other people. We had to see it. It’s one of the fun parts about my day job. We work with people one-on-one all day long, so it’s really one of those things that we can typically see before sometimes people see it in themselves. Often, by pointing it out, we can really help people a lot, so that’s the fun part about it.
Now, on occasion we can’t help, so that’s unfortunate. But it is one of those things. Like anything, behaviorally, it’s sometimes harder to self-identify these things, but it’s not something that you cannot self-identify, especially as you gain some awareness around it.
We’ll be talking through some of the big areas or behavioral tendencies that I have seen come out, what they look like, and how you can potentially avoid mistakes around them.
Behavioral finance is this whole study of people and how they’re not quite as rational or self-controlled. They’re ultimately prone to errors, mistakes, and biases. We’re going to talk about (like I said) some of the big areas that behavioral finance has identified.
The first one that I want to talk through is called overconfidence. You might already be thinking the right direction on this. It is what it sounds like. Overconfidence is this idea that I know really more than I actually do. It’s really common. There’s been a lot of studies on this and they seem to say the same thing.
There was one I was looking at recently, looking at investment fund managers. Seventy-four percent of them said they’re above-average and 26% said they’re average, and then basically 0% of them said they’re below-average. Everybody thinks they’re at least average or above—which is not possible—so this is reinforcing the whole overconfidence thing.
Not everybody is subject to this and it can depend on the topic or how much you know about it. Sometimes, it’s most common when you know enough to be dangerous. You’ve heard people talk about that. What people say when they’re overconfident—because usually, you can acknowledge that people tend to do this—say something like, I know everyone says they’re above-average but I really am above-average.
It’s one of those things you’re like, no, I’m not overconfident, but then, I’m sure there were times when you were. At least I can think of times where I was overconfident. Maybe not in all areas of my life. Definitely not in all areas but in certain times. Like I said, it’s usually when you know enough to be dangerous.
The problem with overconfidence is confidence gives you this feeling of being in control. You’re less likely to exercise caution. It makes you way more prone to mistakes, all along the way considering yourself maybe an expert or more knowledgeable than you really are.
This shows up with investing. Say you’re buying investments, particularly individual investments. Say you bought cryptocurrency in GameStop or whatever individual stocks. You started doing that (say) 2015 or something like that.
From 2015 to 2020, everything’s going up. Your stuff, your trading, your investment choices have done exceptional. You’ve started to see the balances go up, have built up some confidence, and maybe it’s gotten a little in overconfidence level. What happens is you start to feel like you’ve got it figured out.
With investing (at least), inevitably it always goes the other direction. This is where the mistakes often happen. The mistakes can happen when everything is going up, but usually, when everything’s going up, everything is going up, so it’s hard to not make money with general investing.
But when things go down, that’s often when the big mistakes happen. When you have this overconfidence, you don’t really recognize that and you’re prone to those mistakes. They can happen really fast, especially when things go down.
The problem with a lot of these is they’re difficult to self-identify. Ideally, this is where it’s helpful to get another person’s view. This is going to be true with a lot of these. Whether it’s a knowledgeable friend or if you work with a financial planner, this should be something you’re asking them about, especially if you’re pulling the trigger on certain things with your investing.
It’s good to get others’ input on this and then listen to it because they might say something that you don’t agree with. It’s important to remember especially if they have expertise, like they probably know what they’re talking about and it’s probably easier for them to see some of my flaws, and maybe they have a point. So at least be open to other people’s input on this kind of thing. Even your spouse.
If you know enough to be dangerous in that territory, that’s oftentimes where it happens. Sometimes, it happens when you say you know more than enough and you’re an expert—but you’re really not—so that’s probably even more dangerous at the time.
Oftentimes, say the spouse that doesn’t really know much at all, can be bringing up really good points. We ought to get someone else’s opinion because this is not what you do. You don’t spend that much time on it. You’re so busy doing this other thing that you have going on or job or whatever. Sometimes, they can be the voice of reason. Sometimes, it just takes listening to them.
That’s overconfidence. That’s a big one that can come into play. I think it’s most common probably in younger people that have had some experience investing but not a ton of experience. It seems like these big, huge market downturns will teach people some of these lessons through that mistake. So that’s overconfidence. That’s a big one.
Self-serving bias is the next one that I wanted to talk about. Self-serving bias is where you tend to attribute good things or good outcomes to your skill, and bad outcomes to luck. If it’s a bad situation or outcome, you’re going to be like, oh that’s not me. That’s not my fault. Now if it’s good, you’re going to be like, pat on the back.
For self-serving bias, I like the example of school because everybody can relate to this. If you get an A+ on a test, you’re going to be like, wow, I must’ve done so well with my studying. I’m a naturally smart person and I’ve got lots of skills. So, nice job self.
Versus imagine getting the same test score back and you’re like, oh, I got a D-. Then you’re like, well, the teacher didn’t teach what they needed to teach and the books are lacking. There’s no direction. You’re just coming up with excuses. It’s not my fault. It’s external factors.
That’s self-serving bias, and everybody has a little bit of it in them. It can become a major problem with investing especially if you’re involved in pulling the trigger and making decisions.
It’s the same as the test score. You’re going to pat yourself on the back when things are good, and when things go bad, you’re going to look for excuses and blame other people, when in reality it’s probably not quite that way.
With investing, when things go really well, most of the time it’s not you. It might be a little fraction of you, but most of the time it’s not you. Even when they go poorly, it’s often not you. I think with investing, people often attribute success with their investment too much to their own intelligence.
A good way to counter that is to—same thing with overconfidence—getting others’ input; that’s going to be common in these. Also, maybe comparing to more objective comparisons, like how the overall market was doing. That’s always a good wake-up or benchmark check-up on this sort of thing. So that’s self-serving bias.
Hindsight bias is the next one. I’m sure you’ll recognize this. It’s where you think you know more or knew more than you really did in the past. I hear this all the time with people talking about big events.
In 2008, we had the housing bubble crash, and everybody that was around then probably remembers that. Everything tanked. What happens is you start to get people reflecting back on that. A lot of people—not everybody—would talk, like maybe they saw it coming, the writing was on the wall, it was inevitable and everybody knew it’s going to eventually crash.
You create this belief in your head that at that moment in time you did see it coming, but in reality you look back to actual what was going on in the moment before that crash. Nobody knew that that was coming. That’s just not reality. In fact, if you actively knew it was coming, people would make fun of you. That was the least likely thing for people to be bringing on up. One in a million people knew that thing was coming.
There was a movie made about the one dude that knew 2008 was coming. The Big Short. If you haven’t seen that, that’s a good movie. That’s the movie about the only dude that knew 2008 was actually coming, maybe a few more guys and gals. 2008, a lot of people looking back think they knew it was coming but really didn’t.
What happens with this hindsight bias is you start to give yourself more credit than is due, and it goes along with these first three. It leads to more overconfidence, pat yourself on the back—I’m pretty awesome. A lot of these are related.
Confirmation bias is a little different. It’s paying close attention to information that’s confirming your belief and ignoring information that contradicts your beliefs.
My favorite example of confirmation bias is social media. Social media has completely figured out how real of a bias this is. Social media is programmed to put in front of you that’s in line with your values and beliefs, and not put stuff in front of you that’s against those. This totally makes people feel good about this. This is in line with confirmation bias. The same thing with social media.
When you’re investing, if you only take in information in the area of the thing that you believe. Let’s say, you have just gravitated towards this idea. I’m going to go with the one that actually happened lately. GameStop stock was super popular. A lot of people talked about it. It was in the news for a while. They’re buying the one stock and it got crazy.
Say around that time, you really just bought into that idea. The people you hung out with or the […] were online in this group that all talked about it. That was what you were hearing all day long, and all the news stories you got were that. Even your social media started to pop up stuff just on that story. That’s just really pushing you down the same path you’re already going and confirming these beliefs you already have, which causes you to do more of it.
What’s happened with GameStop, for example, it skyrocketed. Then it went way down and went back up. But since that huge skyrocket when it was big on the news, it’s been on a steady trend down. That’s often what happens with these. Even if it does pretty well, the problem with this is it leads you to be less open to other ideas.
This can be any idea, but with investing there are all kinds of good ideas that are out there. Just because you’ve already committed to whatever given ideas you already have being great, that doesn’t mean they’re always going to be great. Or maybe even you’re wrong, and it’s good to consider the other side of the coin. This is one that it’s good to just force yourself to open up to other ideas or alternatives and have that open mind.
Recency bias, the next one, is the one that’s actually similar to hindsight that I was thinking about as I was talking about it. Hindsight bias and recency bias are both looking at the past. But recency bias is honing in on short-term and really overemphasizing the importance of that.
The short-term—which we talked about in the past couple of episodes—in the investing world should not be the focus. It’s a long game. There’s this tendency, though, for people to really just hone in on that.
Let’s say the market tanked. The news says the worst loss in eight million years, everything’s going down, everything’s blowing up, and it’s based on this one-day drop. You’re going to have the tendency to be like, argh. This is a problem because it’s fresh. But if you go back and look at history, there’s actually been a whole bunch of days like this before. Many, many days like this before, if you look at it objectively. In reality, this day is not important.
This is a good one where it helps to refer back to your financial plan and remind yourself of the goals, and the dollars are tied to those goals which should be long-term. You have to have a long view. Recency bias is about having a short view and having a pull towards that. Everybody has a pull that looks at what they recently had happened, but with investing it needs to be a long view. You have to pull yourself away from that, even though there’s that natural tendency.
Anchoring bias is the next one. Anchoring bias is relying too much on pre-existing info or the first info that you come across. It’s latching on.
For example, I’ve seen this with people we worked with one-on-one in the past with their planning. Maybe it’s like my parents lost lots of money in the market. Therefore, I’m going to lose lots of money in the market if I do it, so I’m not going to do it. They’ve latched on to this information that their parents have passed on to them, and they’re adopting that themselves. Or maybe it’s like, my buddy that I hang out with has done really well with real estate investments, so I’m going to do really well.
The problem with it is it’s not adequate information. You’re latching on to a limited, tiny slice of the information, and potentially making huge decisions on that small, tiny information.
With the parents example, maybe they had no idea what they were doing. Or maybe they didn’t lose as much money as they thought they did. Or who knows what happened. Maybe the timing was bad, which is a mistake in itself. There are a lot of things that could’ve happened. It’s impossible to draw a conclusion from it without knowing the entire story of not only the parents, but also, you should probably look at it like what the alternatives could have been for them. The problem with this is not doing a full, adequate analysis.
Loss aversion is the next one I want to talk through. This is where you are just going to be overly fearful of losses. It’s just the pull to avoid losses, kind of like all cost or at greater cost. The research says if you’ve experienced prior losses, you’re going to have an increased chance of having this issue come up in the future, which makes sense. Or maybe other people around you, like the parents example overlaps with this. Maybe you’re pulling in that loss they’ve had and attaching to it.
In down markets when investments go down, it just naturally brings more fear into the equation for everyone. Everyone has that little bit of this. You just see it when you hear people talk about investments a lot more when they go down. This is in play for all of us to a different extent. Some people are painfully fearful to the point where they can’t take any action on anything with any risk.
Insurance companies actually leverage this. They have annuities with floors. They have a cap and floor. They limit the downward exposure. It’s basically capping the losses that you can have. But they come at a huge cost, typically. They basically sell these overpriced products a lot of times in order to help people address this behavioral tendency.
I think a much better approach is to work through that and have some understanding of where the fear is coming from, a little bit of understanding of how markets work—that can help—and understanding how these downturns typically play out, and reminding yourself about the purpose of the dollars and consulting your plan. What’s the money for? Is it a long-term thing? It should be. If so, then this short-term loss is really not a problem because I’m not going to need it short term.
The last one I want to talk about is herd mentality. This is the common one that comes up. It’s like the FOMO—fear of missing out—ties in with that. The tendency for people to follow the masses as opposed to doing their own independent analysis.
Examples of this lately are cryptocurrency, GameStop, I bonds especially lately. This is probably one of the most often ones we see, just snippets of it from people we work with one-on-one. Typically, how it comes up is like, I’ve heard from several of my buddies that XYZ is a good place to put money right now, or something along those lines.
I think it’s different if you work with a financial planner versus if you’re doing it yourself on a lot of these, especially this one. These people that are bringing up to us are doing the right thing. What I would tell you to do is bring it up to another person. Or if you’re doing it yourself, you could bring it up to another person, but they need to know what they’re talking about. Or you need to be doing your own independent analysis.
If you’re putting your entire net worth into cryptocurrency, you really need to understand it backwards, forwards, understand all the risks, and how to fix your planning. It’s important to avoid that pull to go with what the people around you and the masses are doing. That’s where bubbles get created and then they blow up.
Not to say any of these are necessarily bubbles, but you don’t want the herd to drive your decisions. It will pull you behaviorally, like this is what all this research is about. Behavioral finance is the fact that we all have these pulls either way. You don’t want it to pull you so much that it’s affecting your decision-making and causing you to make big errors.
With herd mentality, think about the decisions, where it’s coming from. Are you running it by someone else? If you’re not running it by someone else, are you doing an independent analysis? Or are you just going with what the herd is doing? Thinking through those points (I think) will be helpful.
All right, so that’s behavioral finance in a quick nutshell. This is one of those things, like I said, there’s been huge books written on it. You can dig in a lot on this. I’m happy to get into some of these areas more. Like I said, I enjoy this subject. However, I know it can get pretty intense.
Let us know anytime if you have areas within this or other areas that you want us to dig into in the future, and we’ll definitely plan to do that as we hear from you. Hope you have a great rest of your day and good catching up as always.