When you are making investment decisions, are you confident that your choices are always rational—or have you ever considered that there could be some other factors at work?
Economists and those who study the effects of human behaviour on financial markets have increasingly been turning their attention to the field of behavioural finance—which examines how psychology affects the behaviour of investors and, in turn, impacts markets. One of the main insights stemming from this field of study is that investors often use heuristics, or “rules of thumb” to make financial decisions at the expense of a rational, more measured, analysis. They operate in a world of bounded rationality.
In this article, we will take a look at three basic or core heuristics which may drive investor behavior: anchoring, the “recency effect,” and confirmation bias.
“Understanding behavioural finance provides a lens on the human side of financial decision making that can help us take a more rational view and remain committed to long-term strategies and goals during market upheavals. It can also help us to become more successful as investors, as it orients us with the proper reference points to be forward-looking and opportunity-seeking,” says William R. Horton, Jr., Chief Investment Officer at MD Financial Management.
Anchoring takes place when investors relate to a fixed number, value or stock price as a mental reference point, or “anchor.” Once the fixed anchor point has been created, the investor then focusses on this single value, as opposed to conducting a complete analysis when a decision is required. This reference point unduly influences decisions that follow.
When is anchoring a problem? Anchoring shows up when investors watch a stock price drop to a low price from a high one—and then refuse to sell until the previous high is matched. While, in reality, the previous high has no direct relation to where the stock price may go in the future (and there is no guarantee the anchor value will ever be attained again), it has now become an “anchor” in a faulty decision-making process.
The “recency effect” is a cognitive bias (or form of bounded rationality) in which people place more importance on recent observations or events than is actually warranted.
For example: Consider the number of people who say they are reluctant to fly in the days following news of a plane crash. The probability of a similar crash in the future has not changed, but the perception of the riskiness of flying has changed due to recent events. This bias can also be witnessed after dramatic fluctuations in the markets—after which investors perceive stock market investing as “more risky” than prior to a fluctuation.
Confirmation bias occurs when people look for evidence to confirm their existing beliefs, while overlooking evidence which contradicts them. For investors, this selective thinking can lead to a focus on information that supports a preferred investment idea, rather than obtaining all relevant information before acting.
How can you avoid harmful bias?
Heuristics are persistent because they help us make decisions quickly, especially when we are faced with complexity and uncertainty. But relying too heavily on rules of thumb can hinder investors from reaching their financial goals if using heuristics means acting before a fuller picture has been developed.
An insightful article references a study which suggests that in many instances, smarter people are actually more vulnerable to these thinking errors than previously thought. “Although we assume that intelligence is a buffer against bias,” summarizes the article, “it can actually be a subtle curse.”
The study, published in the Journal of Personality and Social Psychology and carried out by researchers at James Madison University and the University of Toronto, found that “more cognitively-sophisticated participants showed larger bias blind spots”— referring to our inability to identify our own thinking errors (although we may readily spot them in others). “This trend [indicates] that smarter people…and those more likely to engage in deliberation were slightly more vulnerable to making mental mistakes,” concludes the New Yorker story.
One of the ways in which investors can help ensure they do not fall victim to behavioural biases is to enlist experts in their financial decision-making processes. If you are concerned about ensuring your decisions are not influenced by behavioural bias, it is important to consult with a professional financial advisor to determine which strategies will work best for you and your situation.
“It is especially important to not let your risk tolerance be overly affected by anchoring, recency or confirmation bias. One of the best ways to help avoid these harmful shortcuts in thinking is to seek the perspective of your MD advisor,” says MD CIO Horton.