Behavioral Finance and Your Portfolio. Michael M. Pompian
how people operate under bias, but no universal theory has been developed (yet). Instead of a universal theory of investment behavior, behavioral finance research relies on a broad collection of evidence pointing to the ineffectiveness of human decision making in various economic decision-making circumstances.
Why Understanding and Identifying Behavioral Biases Is Crucial
By understanding the effects that behavioral biases have on the investment process, investors may be able to significantly improve their economic outcomes and attain stated financial objectives. As noted in Chapter 1, during my 30+ year career advising clients, I have found that recognizing and managing the most frequently occurring behavioral biases is crucial to obtaining financial success. For many years I have had my “Top 3” most common behavioral biases—Loss Aversion, Confirmation and Recency biases. Coincidentally, a recent study by Charles Schwab confirms my Top 3, albeit in a slightly different order as can be seen in Figure 2.1 which illustrates how often financial advisors see each bias in the clients they serve. If you are short on time, and you want to only review the most common biases, skip ahead to the chapters containing Loss Aversion, Confirmation, and Recency biases.
Figure 2.1 Most Significant Behavioral Biases Affecting Client Investment Decisions 2019
Source: Charles Schwab
In my experience, simply identifying a behavioral bias at the right time can save investors from potential financial disaster. During my 30+, spanning numerous economic meltdowns, including but not limited to 1987 (my first year in the business), 1998, 2001, 2008–2009, 2018, and 2020, I've talked many of my clients “down from the ledge” and out of selling their risky assets at the wrong time due to irrational panic behavior. In fact, many of my long-time clients are now used to volatility and do not panic. They look at market drops as buying opportunities. This behavior-modifying advice has helped investors to reach their financial goals. In other cases, I was able to identify a behavioral bias or a group of biases and decided to adapt to the biased behavior so that overall financial decisions improved and the most appropriate portfolios were built—that is, one the investors could stick to over time. It is crucial for you to understand how you make decision to build the best portfolio for you. For example, some investors have a gambling instinct, or want to take risks with some of their capital. My advice in many of these cases is to carve out a small percentage of the portfolio for risky bets, leaving the vast majority of wealth in a prudent, well-organized portfolio. In short, knowledge of the biases reviewed in this book and the modification of or adaption to irrational behavior may lead to superior results.
How to Identify Behavioral Biases
Biases can be diagnosed by means of a specific series of questions. In this book, Chapters 3 through 22 contain a list of diagnostic questions to determine susceptibility to each bias. In addition, a case-study approach is used to illustrate susceptibility to biases is given with advice on how to build portfolios. In either case, investors who wish to incorporate behavioral analysis into their portfolio management practices will need to administer diagnostic “tests” with utmost discretion, especially at the outset of a relationship. When one becomes very good at diagnosing irrational behavior, it can be done without fanfare or much notice. As one gets to know their biases, better portfolio outcomes are the result.
Categorization of Behavioral Biases
In its simplest form, cognitive biases are those biases based on faulty cognitive reasoning (cognitive errors), while emotional biases are those based on reasoning influenced by feelings or emotions. Cognitive errors stem from basic statistical, information processing, or memory errors; cognitive errors may be considered to be the result of faulty reasoning. Emotional biases stem from impulse or intuition; emotional biases may be considered to result from reasoning influenced by feelings. Behavioral biases, regardless of source, may cause decisions to deviate from the assumed rational decisions of traditional finance. A more elaborate distinction between cognitive and emotional biases is made in the next section.
Differences between Cognitive and Emotional Biases
In this book, behavioral biases are classified as either cognitive or emotional biases, not only because the distinction is straightforward but also because the cognitive-emotional breakdown provides a useful framework for understanding how to effectively deal with them in practice. I recommend thinking about investment decision making as occurring along a (somewhat unrealistic) spectrum from the completely rational decision making of traditional finance to purely emotional decision making. In that context, cognitive biases are basic statistical, information processing, or memory errors that cause the decision to deviate from rationality. Emotional biases are those that arise spontaneously as a result of attitudes and feelings and that cause the decision to deviate from the rational decisions of traditional finance.
Cognitive errors, which stem from basic statistical, information processing, or memory errors, are more easily corrected for than are emotional biases. Why? Investors are better able to adapt their behaviors or modify their processes if the source of the bias is illogical reasoning, even if the investor does not fully understand the investment issues under consideration. For example, an individual may not understand the complex mathematical process used to create a correlation table of asset classes, but he can understand that the process he is using to create a portfolio of uncorrelated investments is best. In other situations, cognitive biases can be thought of as “blind spots” or distortions in the human mind. Cognitive biases do not result from emotional or intellectual predispositions toward certain judgments, but rather from subconscious mental procedures for processing information. In general, because cognitive errors stem from faulty reasoning, better information, education, and advice can often correct for them.
Difference among Cognitive Biases
In this book, we review 13 cognitive biases, their implications for financial decision making, and suggestions for correcting for the biases. As previously mentioned, cognitive errors are statistical, information processing, or memory errors—a somewhat broad description. An individual may be attempting to follow a rational decision-making process but fails to do so because of cognitive errors. For example, they may fail to update probabilities correctly, to properly weigh and consider information, or to gather information. If corrected by supplemental or educational information, an individual attempting to follow a rational decision-making process may be receptive to correcting the errors.
To make things simpler, I have identified and classified cognitive biases into two categories. The first category contains “belief perseverance” biases. In general, belief perseverance may be thought of as the tendency to cling to one's previously held beliefs irrationally or illogically. The belief continues to be held and justified by committing statistical, information processing, or memory errors.
Belief Perseverance Biases
Belief perseverance biases are closely related to the psychological concept of cognitive dissonance, a bias I will review in the next chapter. Cognitive dissonance is the mental discomfort that one feels when new information conflicts with previously held beliefs or cognitions. To resolve this discomfort, people tend to notice only information of interest to them (called selective exposure), ignore or