Stordahl Capital Management’s Evidence-Based Investment Insights: Insight #12: Behavioral Biases – What Makes Your Brain Tick?

Welcome to the next installment in our series of SCM’s Evidence-Based Investment Insights: Behavioral Biases – What Makes Your Brain Tick?

In our last piece, “The Human Factor in Evidence-Based Investing,” we explored how our deep-seated “fight or flight” instincts generate an array of behavioral biases that can trigger unsound investment decisions—such as buying when markets are high and selling when they are low. Here, we’ll familiarize you with a half-dozen additional biases and how to recognize the signs of these behavioral booby traps.

Behavioral Bias #1: Herd Mentality

Herd mentality is what happens when you see a market movement afoot, and you decide to 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 pandemic or a country in economic turmoil. Either way, as we covered earlier in  “Ignoring the Siren Song of Daily Market Pricing,” following the herd puts you on a dangerous path toward buying high, selling low, and incurring unnecessary costs along the way.  

Behavioral Bias #2: Recency

Even without a herd to spur you on, your long-term plans are at risk when you give recent information greater weight than the long-term evidence presents. From our earlier discussion in “The Business of Investing,” 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 look for a “safe harbor.” Vice versa when bull markets are on a tear: Investors pile in, chasing after past returns.

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 that supports our belief structure; we’ll discount that which might prove us 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”” is so critical to objective decision-making. Without it, your brain wants you to be right so badly it may rig the game against your own best interests.

Behavioral Bias #4: Overconfidence

In “Your Money & Your Brain,” Jason Zweig describes overconfidence in action when he asks: “How else could we ever get up the nerve to ask somebody out on a date, go on a job interview, or compete in a sport?” In these and similar scenarios, a degree of overconfidence can be good. But it often becomes dangerous in investing. Overconfidence tricks us into believing we can consistently beat the market by being smarter or luckier than average. In reality, as we described in “You, the Market, and the Prices You Pay,” it’s best to patiently participate in the market’s expected returns instead of trying to go for broke—potentially literally.

Behavioral Bias #5: Loss Aversion

As a flip side to overconfidence, we are also endowed with an oversized dose of loss aversion. In fact, academic insights suggest we dislike the thought of losing money about twice as much as we enjoy the prospect of receiving more of it.

One way that loss aversion plays out is when investors prefer to sit in cash or bonds during bear markets or even when stocks are going up but a correction “feels” overdue. The evidence clearly suggests you will likely end up with higher long-term returns by at least staying put in the market, if not bulking up on stocks while they’re relatively cheap. But even the potential for future loss can be a more compelling stimulus than the higher likelihood of long-term returns.

Behavioral Bias #6: Sunken Costs

We investors also have a terrible time admitting defeat. When we buy an investment that sinks lower, we’re reluctant to lose our initial stake. Anchoring, another bias, may convince us to avoid selling anything until we can at least recover our sunken cost.

In a data-driven strategy (and life in general), the evidence is strong that this sort of logic leads people to throw good money after bad. In the long run, it’s essentially irrelevant whether an individual holding in your portfolio has gone up or down. By refusing to let go of it once it no longer suits your greater purposes, an otherwise solid investment strategy gets weighed down by emotional choices and debilitating distractions. The better question guiding when to hold and when to sell is whether or not a holding continues to make sense within your overall portfolio.

Your Take-Home            

So, there you have it. Six behavioral biases, with many others worth exploring. We recommend that  you take the time to learn more. First, it’s a fascinating field of inquiry. Second, it can help you become a more confident investor. Following are a few of our favorite books on the subject:

The insights you’ll discover are likely to enhance other aspects of your life as well. But be forewarned: Even once you know your behavioral stumbling blocks, it’s still difficult to avoid tripping on them. By definition, your instincts fire off lightning-fast reactions in your brain well before logical thinking kicks in. This is one reason we suggest working with an objective advisor: to help you see and avoid the collisions that your own myopic vision might miss.

In the next and final installment of SCM’s Evidence-Based Investment Insights, we’ll tie together the insights shared throughout the series. 

We would be happy to speak with you individually about the latest evidence on factor investing and how to apply it to your investment strategies best.  We offer a complimentary 15-minute call to answer your questions and to share how we can help.

This information should not be construed as investment, tax, or legal advice. This commentary reflects the personal opinions, viewpoints, and analyses of the Stordahl Capital Management, Inc. employees providing such comments and should not be regarded as a description of advisory services provided by Stordahl Capital Management, Inc. or performance returns of any Stordahl Capital Management Inc. Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this piece constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Accessing websites through links directs you away from our website. Stordahl Capital Management is not responsible for errors or omissions in the material on third-party websites and does not necessarily approve of or endorse the information provided. Users who gain access to third-party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from the use of those websites. Please note that trading instructions through email, fax, or voicemail will not be taken. Your identity and timely retrieval of instructions cannot be guaranteed. Stordahl Capital Management, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

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