Commentary

Biases Don't Make Investors Foolish

Steve Wendel

Confirmation bias. Herding behavior. Loss aversion. Anchoring. The field of behavioral finance is perhaps best known for the laundry list of investor biases that researchers have documented. These cognitive biases push investors to make common mistakes when it comes to investing: overtrading, chasing returns, running from a down market, and so forth. The research can give the impression that investors are simply foolish and should not be trusted with their money. As a behavioral scientist, I want to dispel that view. It's dangerous to our understanding of investing and can make it harder for investors to succeed.

On Hamburgers
Here's an example I use to explain to advisors and other industry professionals what the biases of investing really are. Imagine you're in the mood for a burger (or your favorite food). When it comes to buying hamburgers, there are some simple, straightforward rules we use to pick burgers that we're likely to enjoy even before we eat them. 

Let's say you’re going out to eat, you pass two restaurants, and you happen to see their food on display. One of the burgers looks smashed up, greasy, and artificial (think about your least-favorite fast-food place), and the other looks plump and inviting. You don't stand there, frozen in place for an hour, carefully thinking over which one might be better. Instead, you can quickly take a reasonable guess, based on how it looks and on your intuition.

If you couldn't see the food itself, but you had eaten at the restaurants before, you'd still be OK. You can use your past experience as a reasonable guide. The burger place you enjoyed before will likely be the best choice now, too.

If you're in a new city, and you have no prior experience, you can always look at what other people do. The restaurant with lots of people probably has better food than the one that is eerily empty.  

If you look at the prices, and one hamburger is much cheaper than the others, there's probably something wrong. Stay away.  

And Investing
Let's apply the same logic to investing.

When we're first confronted with an investment option, our minds often have an immediate and intuitive response: a nondeliberative, gut feeling about it. As behavioral scientists, we call that a System 1 reaction, and it can often lead us astray.

We all know that past performance does not predict future performance, and basing our investment decisions on it can be potentially disastrous. Yet our minds naturally want to project from the past; we call that recency bias.

If you get excited as an investor and follow what lots of other people are doing, that can also be quite dangerous. We call that herding behavior.

If you only go for high-priced stocks (relative to value), you're likely to get burned. We call that a misapplied heuristic: price as a signal for quality. When, in reality, lower price, all else being equal, means increased profit with investments.

What This Means for Investor Success
These are four examples of major biases: four ways in which investors can be derailed. Are these signs of foolishness? Not at all. They are shortcuts that our minds take, which in everyday life are immensely valuable. It's just that investing is bizarre. The normal rules of life don't necessarily apply here, and our minds don't know this. That's why as investors, we all get into trouble.

What does that mean for investing biases and how they should be handled?

The decisions our minds make, which we call biases in the context of investing, are actually quite smart. Investment biases are smart shortcuts, applied to the wrong situation. Thus, there's a very good reason why they are difficult to overcome: they generally help us. Since we can't simply ignore them or easily override them, we have to acknowledge them and work with them or around them. Everyone has them: advisors, fund managers, pension investment committees, etc. Our investment biases are a natural part of how our minds are wired; they don't disappear because someone has a particular base of expertise in investing.

None of this means that investors are "off the hook" and always act wisely when it comes to investing. It's rather that the sometimes condescending tone in the investing world about investors is way off base. To be more effective investors, we need to understand the value that our shortcuts offer, and find ways to use these shortcuts to our advantage or how to otherwise avoid them. 

This article is adapted from my presentation at the U.K. Morningstar Investment Conference last week.