Learning from Behavioral Finance

In the investment world, behavioral finance is a hot field. I consider the teachings of behavioral finance an invaluable tool in my financial advisory work with clients. The concepts have also helped me tremendously in the operation and growth of my own business, Gerstein Fisher, over the last 20 years.

The traditional finance world of modern portfolio theory assumes that investors act rationally, exhibit risk aversion, and consider all available information in their investment decision-making process. In other words, it describes how investors should act.

By contrast, behavioral finance teaches that, as humans, we are not always rational or driven by logic. Rather, investors are emotional and bring cognitive and behavioral biases to financial decisions and are thus prone to making systematic errors. Therefore, behavioral finance tries to explain how investors (and markets) do act—in other words, practice versus theory.

If we can just know ourselves, then perhaps we can identify our cognitive or behavioral biases and take steps to mitigate them. Here are several examples:

Conservatism Bias

This is a belief perseverance bias in which investors place too much weight on their initial beliefs and underreact to new, conflicting information. Rational investors would revise their expectations and forecasts with the receipt of new, relevant information. In the real world, however, people are often anchored to prior probabilities. For instance, consider the case of an iconic American manufacturer of 35mm film that failed to react to the advent of new technologies. Business owners should ensure that they are flexible enough to incorporate new information into their investment and business decisions and are not wedded to prior beliefs.

Confirmation Bias

This is an extremely common problem with investors, including professionals such as security analysts and fund managers. Here, individuals, looking for confirming evidence, tend to notice only information that agrees with their perceptions or beliefs. In other words, they focus on the positive information related to an investment and ignore or dismiss evidence that contradicts their views. Many businesspeople are prone to making the same mistake. We have great vision; however, we overlook much that is obvious to any outsider. One way to ameliorate this bias, obviously, is to make a habit of inviting, or hiring, independent-minded people to debate the wisdom of a business or investment idea with you.

Loss-Aversion Bias

Rather than focus on risk relative to return, investors instead focus on gains and losses. In fact, investors feel the pain of loss more than twice as much as the pleasure of gain. Investors so abhor taking losses that they tend to continue holding loss-making stocks in the hope of eventually breaking even, and they sell winners too early in order to realize gains instead of risk losing the profits. With such habits, investors are unwittingly increasing their risk-seeking behavior. 

Consider several companies in the once-proud Japanese consumer electronics industry that have dug deep financial holes for themselves by stubbornly refusing to cut chronically loss-making lines of business. Or, consider the many times we hold on to under-achieving salespeople because they once closed a great deal. Businesspeople often need to overcome their emotions and cut losses for the sake of the firm’s future.

Regret-Aversion Bias

In this one, investors feel regret either from taking or not taking action. In investment or business, this can cause people to stay in low-risk investments out of fear of losing money from taking risk. This results in portfolios with limited upside potential, which may increase the likelihood of the investor not meeting her long-term goals. Regret aversion also induces investors to follow the herd, even as it enters a bubble. Think of investors who piled into tech stocks in the late 1990s and residential property in the mid-2000s to avoid the regret of not keeping up with the herd. All too often, business owners feel compelled to follow their peers into an overcrowded line of business instead of analyzing the situation independently.

Status Quo Bias

Finally, I wanted to make special mention of problems that commonly afflict employees who invest their savings in a company defined-contribution plan, such as a 401(k). One common situation is where employees are so overwhelmed by the menu of mutual fund choices in the plan that they simply invest equal amounts of retirement money in each fund, which from a portfolio allocation standpoint often makes no sense at all. There’s even a term for this: 1/n naïve diversification, where n represents the number of funds on offer.