On this episode of The Impatient Investor, Andrew states that behavioral science is grossly underutilized as a way to study investment behavior. Understanding our predispositions in a time of economic uncertainty will go a long way towards understanding behavioral biases that prevent us from making good investment decisions.
“There is one field in which behavioral science is grossly underutilized, and that’s in the field of behavioral finance or the study of influence of psychology on investment behavior.”
I’ll be the first to say it. I’m no behavioral expert nor do I aspire to be one. Still, I’ve been around the block long enough to recognize that human actions and behaviors are shaped by a variety of factors, including our family backgrounds, life experiences, and even genetics. Human behavior is such an important topic that an entire branch of academia is devoted to it in the field of behavioral science. There are thousands of books dedicated to the subject.
In the real world, Behavioral science has practical applications in a variety of fields, including therapy, self-improvement, relationships, and even group behavior. There is one field in which behavioral science is grossly underutilized, and that’s in the field of behavioral finance or the study of influence of psychology on investment behavior.
In a time of extreme economic turmoil caused by the COVID-19 pandemic, where we’ve seen the stock market shed as much as 33% of its value, perhaps behavioral science is worth visiting since panic-induced investment decisions can end in disastrous results for many investors. In economic downturns like the one we’ve seen recently, Warren buffet likes to tell investors to go against their instincts and to be fearful when others are greedy and greedy when others are fearful.
You may be thinking that’s easy for Warren buffet to say, he’s got 460 billion in market cap to fall back on with his investment from Berkshire Hathaway. What about the rest of us? For the rest of us it’s hard to hold your nerve to go against our natural urges, like the Sage of Omaha in these times of extreme uncertainty. Warren buffet and history will tell us just like with every other downturn, this too will pass. But in the midst of the storm, history is swept under the rug and dark clouds can make it feel impossible for any investor to know whether to sell, hold steady or as Warren buffet suggests to be greedy and buy.
Many experts suggest that the step towards making the right decision should include a basic understanding of human behavior towards learning to separate our animal instincts from our investment decision-making process. Many investors will discover that these animal instincts may inform embedded personal biases that make for bad investment Decision-making.
The starting point for understanding our biases starts with the most basic of instincts, the human fear response. The human fear response while useful in making decisions of life and death like fleeing from a stampeding herd of mammoths is not particularly useful and can be downright harmful when it comes to making investment decisions, especially in a downturn.
Embedded in all of us is basic fight or flight instinct that’s triggered in the face of danger. This instinct served to preserve our ancestors in the face of hazards like saber-tooth tigers, marauding bandits, natural disasters, and the like. In the face of stock market danger and uncertainty, investors react to fear in much the same way our ancestors did in the fear of physical danger, fight or flight.
Unfortunately, because investors have no control over the stock market, they can’t fight it. Investors feel they only have one choice, flight, to run away and withdraw all their investments and cut their losses. Although flight is the most common reaction in times of economic stress. History has proven that fleeing is probably the worst thing investors can do in a downturn. That’s because markets always rebound and investors who sell off and flee to a cave of their own making will typically be overcautious and take way too long to emerge from that cave. What ends up happening is that while they sold off at the bottom, they end up overpaying on the upswing because they wait too long, making the road back that much longer and harder.
Understanding behavioral finance will help investors avoid making the typical sell low – buy high investment mistake they’ll regret later when the markets inevitably calm down. In uncertain times, like the ones we’re living through right now, it’s hard for investors to think with a straight head and easier to fall back on decision-making behaviors that were shaped long ago when our ancestors roamed the icy Plains with Spears. Fear kicks in, It’s a natural biological response.
But as a 2016 study by The University of Pittsburgh published in the journal of neuroscience concluded, anxiety and fear typically lead to bad decision-making. Understanding the fear and anxiety that can inform our behavioral biases, biases that lead to bad investment decisions can go a long way towards helping us overcome these biases on the path to not only surviving but as Warren buffet even suggests thriving in the times of economic danger. Be leery of the following types of behavioral biases that will prevent you from making good investment decisions.
Number one, loss aversion. That’s the feeling of wanting to avoid a loss and doing all we can to reduce the chance of it’s happening. The evidence suggests we feel losses at least two or three times as strong as we feel an equivalent gain. In other words, the risk of the pain of losing far exceeds the potential payoff. This bias drives us to actions to avoid losses rather than those that will result in gains. We’ll take the road to avoid the cliff rather than take the road that will lead us to the treasure.
Number two, Endowment effect. That’s placing more value on something we own more than something we don’t own. This bias means that we often hold on to investments long after they become irrelevant to our goals. And long after in alternative investment would better serve our long-term purposes and goals.
Number three, regret aversion. This is where people think the worst possible outcome and how they would feel if the outcome was realized. This leads people to choose options that reduce or eliminate the chance of regret. Even if the decision is not the right one.
Number four, status quo bias. People gripped by this bias don’t like change. They prefer things to stay the same. So they’ll do nothing or stick with a choice that they’ve already made. This is why people stick to investment options like stocks and bonds and mutual funds that they’re familiar with, or that their advisors recommend rather than switching to something else to change a losing investment strategy. Unfamiliarity makes them nervous.
Number five, disposition effect. This is where we tend to hold onto losing investments for too long while selling, winning investments too quickly. This is closely linked to loss aversion.
And number six, herding bias. This is a compulsion to follow the crowd and a natural discomfort when you feel like you’re going out on a limb. Back to the stampeding herd of mammoths example, if you saw your buddies running for their lives, you didn’t ask any questions, even if you couldn’t see the mammoth in the distance. All you know is that if you didn’t follow the crowd, you were going to be the one that get trampled. In dangerous financial times, we have the choice between doing the sensible thing or doing what’s comfortable and what we’re predisposed to do because of our behavioral biases. Faced with economic fears and anxieties, our biology tells us to flee, to retreat and stay hidden, to avoid loss, to stick to what we’re used to. But as we’ve established, investment decisions clouded by fear and anxiety are often the wrong decisions.
Understanding our pre-wired predispositions in a time of extreme economic uncertainty will go a long way towards understanding behavioral finance and the behavioral biases that prevent us from making good investment decisions. By understanding these biases, we can begin to overcome them and avoid bad investment decisions. Only then can we learn to stand firm and turbulent times and do as Warren buffet recommended, be greedy when others are fearful.