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Predicting Irrational Behavior

An anchoring bias in clients is also often associated with regret, loss aversion, and representativeness--all of which can be harmful to returns.

Michael M. Pompian, 01/19/2012

This month's article is the fourth in a series called "Managing Behavior in a Volatile Market" and Part I of another important bias, anchoring. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion 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 Morningstar.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 just hit the cyber-market.

As noted in earlier articles, 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. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?

The purpose in doing this is that 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 a range of a client's behavioral 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 current situations 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. For example, 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 anchoring bias. Sixty-one percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to anchoring (i.e., when thinking about selling an investment, the price they paid is a big factor they consider before taking any action). Of that group, at least half were also subject to the following six biases:

1. Regret (65%)
2. Loss Aversion (63%)
3. Representativeness (61%)
4. Availability (54%)
5. Outcome (52%)
6. Status Quo (51%)

For example, of the respondents who said they were subject to anchoring, 65% of them were also subject to a question designed to identify regret bias, and so on for the other five biases.

In this article, I will provide commentary on the first three of these biases, regret, loss aversion, and representativeness. I will discuss why these biases are linked with anchoring bias and what one can do to counsel a client with these biases. Next month, in Part II, I will discuss availability, outcome, and status quo in connection with anchoring.

Anchoring and Regret
Anchoring and regret biases are naturally tied together. Doesn't it make sense that if investors consider the price they paid, potentially irrationally so, for an investment prior to taking further action on that investment (i.e., buying more, selling, or holding), they might also be wary of making a decision they might regret in the future?

Regret-aversion bias is an emotional bias in which people tend to avoid making decisions that will result in action because they fear the decision will turn out poorly. Simply put, people try to avoid the pain of regret associated with bad decisions.

Regret aversion can keep some investors out of a market that has recently generated sharp losses or sharp gains. When deciding, for example, whether or not to sell a losing position, our instincts tell us that we might have serious regret if the investment rallies in the future back to or above the price originally paid. Yet it is often the case that "the first loss is the best loss." Taking the loss and putting the money back into a more productive investment may indeed be the wisest course of action. Regret aversion can persuade us to stay in a losing investment too long.

Advice: Counsel your clients that they will make investment mistakes. Everyone does (even you!). The best investors in the world make meaningful mistakes. Don't be afraid to admit you made a mistake and take a loss if it's the best course of action.

Anchoring and Loss Aversion
As we saw in a prior article, loss aversion and anchoring are naturally tied. It should make sense that if one feels the pain of losses, they are doing so in reference to a starting point. For example, if Jim buys a stock fund at $100 and it goes down to $80, he is not going to be happy. He is likely to get "anchored" to the $100 purchase price because that is the point at which he will "break even" and stop the pain associated with losses.

Further suppose this stock fund was purchased in a highly overvalued asset class (Jim did not do enough research before he bought it). Even with the loss, the asset class is still overvalued. The prospects for the fund are not so good. What will Jim do?

Paradoxically, many investors accept more risk to avoid losses than to achieve gains. Loss aversion may lead Jim to hold this loser even if the investment has little or no chance of going back up anytime soon.

Similarly, loss-aversion bias leads to risk avoidance when people evaluate a potential gain. Given the possibility of giving back gains already realized, investors often lock in profits, thus limiting their upside.

Advice: Because loss aversion is an emotional response to losing money, it is often difficult to correct. Anchoring is a bit easier to correct for in that a reference point can easily be identified. What I recommend is that advisors focus their clients' attention not on the purchase price but rather the prospect of a positive result from the current price. Would you make the investment now? If the answer is yes, then holding is the right course of action. If the answer is no, the right course of action is to sell.

Anchoring and Representativeness
Although it may not be obvious, anchoring and representativeness are related. At its core, representativeness bias is the idea that some investors tend to use prior experience as a frame of reference for current decisions. (Technically speaking representativeness bias is a belief perseverance bias in which people, when confronted with new information, use pre-existing beliefs to help classify the information even if the new information does not necessarily fit an existing belief.)

If a client had a prior investing experience in which he sold a losing investment only to see it rally at some point in the future (even years later), he may use this information when considering a current decision--potentially disregarding important considerations such as the prospects for the investment or valuation.

Advice: As I have said in the past, advisors need to encourage their clients to judge every investment idea on its current merits, not based on past experiences. Not always easy! Investment ideas and asset classes go through cycles of attractiveness and unattractiveness. Be flexible in your thinking! And, most importantly, pay attention to valuation.

Hopefully you have learned something about anchoring and the biases connected with it. When you encounter a client with anchoring tendencies, think about the biases you have read about in this article. It might help to build a better client relationship! In next month's article, we will review Part II of 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.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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