A closer look at how hindsight bias, availability bias, and status quo pitfalls can be related to investors' loss aversion.
This month's article is the third in a series called "Managing Behavior in a Volatile Market" and Part II of a very important bias: Loss Aversion. This new series will provide data and insight into not only identification of key behavioral biases that your clients are likely to exhibit but also how to manage these behaviors and emotions in this highly volatile market environment.
A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morninstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.
By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies, has just hit the cyber-market.
The intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases") so advisors would know what to look for when working with their clients. Secondly, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client ABC has easily recognizable bias X, what other of the 19 biases might Client ABC also be subject to?
The purpose in doing this is so advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into the range of a client's behaviorial tendencies simply by being aware of a single common bias.
In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias. There were seven biases that garnered at least 50% positive responses:
Loss Aversion Bias: The pain of losses is greater than the pleasure of gains
Anchoring Bias: Getting "anchored" to a price point when making an investment decision
Hindsight Bias: Believing that investment outcomes should have been able to be predicted
Recency Bias: Taking investment action based on the most recent data or trend rather than putting the current situation into historical perspective
Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference
Status Quo Bias: Not taking action to change one's investment portfolio (i.e., doing nothing when prompted to do so)
Regret: Past (poor) decisions affect future investment decisions
When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. Further, let's say you identify that a client is loss averse? What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.
In this article we will review the biases associated with loss aversion. Fifty-eight percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to loss aversion (i.e., if the pain of losses is at least two times the pleasure of gains). Of that group, at least half were also subject to the following six biases:
1. Anchoring (67%)
2. Regret (61%)
3. Representativeness (61%)
4. Hindsight Bias (57%)
5. Availability (53%)
6. Status Quo (53%)
For example, of the respondents who said they were loss averse, 67% of them were also subject to a question designed to identify anchoring bias, and so on for the other five biases.
What I will do in this article--Part II of Loss Aversion--is to provide commentary on the second three of these biases, Hindsight, Availability, and Status Quo. (Click here to read Part I of Loss Aversion). I will discuss why these biases are likely linked with loss aversion and how one can counsel a client with these biases.
Loss Aversion and Hindsight
Loss Aversion and Hindsight are quite related. Hindsight bias occurs when people see past events as having been predictable and reasonable to expect. People tend to remember their own predictions of the future as more accurate than they actually were because they are biased by the knowledge of what has actually happened.
In other words, to alleviate discomfort associated with an unexpected occurrence, people tend to view things that have already happened as being relatively inevitable and predictable. This view is often caused by the reconstructive nature of memory. When people look back, they do not have perfect memory; they tend to "fill in the gaps" with what they prefer to believe. In doing so, they may prevent themselves from learning from past mistakes.
When connecting this bias to loss aversion, we can have a situation in which investors may feel confident in themselves by believing, for example, that their own investment acumen was the reason a certain investment did well, even if another investment they thought was going to do well did just the opposite. In order to preserve their belief in themselves, they engage in loss averse behavior such as holding the losing investment even if it has no prospect of a rebound.
Advice: Hindsight bias often causes investors to overestimate the degree to which they predicted an investment outcome, thus giving them a false sense of confidence for future investments. When an investment appreciates for reasons other than expected, it is important to make note of this fact because it is easy to fall into the trap of thinking, "I'm smart because this investment did well," but it may have done so for the wrong reason(s).
Similarly, you may have had an investment thesis that was exactly right, but some other events may have caused the investment to perform poorly. This is the random nature of investing. Always try to be introspective and challenge your assumptions. This will make you and your clients better investors in the long run.
Loss Aversion and Availability Bias
Loss Aversion and Availability do not intuitively seem related, but I will try to make sense of this connection. In a strict sense, availability bias occurs when people use a heuristic approach (also known as a rule of thumb or a mental shortcut) to estimate the probability of an outcome based on how easily the outcome comes to mind. Recent events are much more easily remembered and available.
In the context of the survey, the meaning of Availability was altered a bit to inquire as to how likely the respondent was to take an action based on information that was available and that also made sense to the person. (It's difficult to ask survey-takers if they use "available information." Of course they do!). So in this case, the question asked how quickly do you take action on ideas that make sense to you (i.e., quickly means they are subject to availability bias). In terms of loss aversion, perhaps this behavior is what gets investors into a loss situation to begin with--they make an investment too quickly without considering all the facts--and then they are unwilling to sell when they figure out it wasn't a wise move.
Advice: My advice to those investors subject to Availability is to make sure they do their research or at least understand why an investment is being recommended. This way, if an investment goes down, they can assess whether or not they should continue with the investment.
Loss Aversion and Status Quo
Loss Aversion and Status Quo are naturally tied. This bias is similar to regret, which we discussed in Part I of Loss Aversion. Some investors are generally more emotionally comfortable keeping things the same than they are with making a change, and thus they do not necessarily look for opportunities where change is beneficial. Given no apparent problem that requires a decision, the status quo is maintained. Further, if given a situation where one choice is the default choice (i.e., keep things the same), people will frequently let that choice stand rather than opting out of it and making another choice.
Advice: Getting investors who do not wish to take action to "get off the dime" and make some decisions is not easy, and demonstrating through quantitative analysis is not always effective. Similar to regret, what I often recommend is to take action in smaller increments. For example, if the task is to get invested, then clients can "average in" to the markets--taking three months or six months to get fully invested. This often puts the fear of losses aside; if an investment goes down, you can buy more at lower prices.
Hopefully you have learned something about Loss Aversion and the biases connected with it. When you encounter a client with Loss Aversion, remember the biases you have read about in this article. It might help to build a better relationship! In next month's article, we will review the biases associated with Anchoring.
Michael M. Pompian, CFA, CFP is an investment consultant to ultra-affluent clients and family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients.