How our behavioral biases impact investment decision-making (Part II)

In part one of our series examining the behavioral biases that can adversely affect investment decision-making, we explored the impact of prospect theory, loss aversion, and recency bias as three of the key factors that explain why the returns of average individual investors have historically lagged the S&P 500® by nearly 50%.

We now turn our attention to three additional behaviors and emotions that often lead us to do the wrong things at the wrong time with our money—specifically our propensity for familiarity and framing biases, as well as our tendency to rely on mental accounting.

Familiarity bias

Familiarity bias refers to the mental shortcut investors often take—leaning heavily on our past familiar experiences when faced with making new decisions. We tend to assess the likelihood of a certain outcome based on the ease with which we can recall similar outcomes having occurred before.

We often see this displayed in the partiality investors show towards stocks from their home country, the industry and company they work for, or specific products and services they frequently use and for which they have a strong positive opinion. 

Did you know?
Even though more than 40% of global GDP is generated outside of the U.S., on average U.S. investors only have about 15% of their stock portfolios invested in overseas markets?¹

Employees of publicly traded companies will often hold the majority of their retirement plan assets in company stock. They may even hold shares of company stock in their taxable brokerage account as well. Typically, they rationalize the decision based on having a fairly strong understanding of the company’s vision, business activities, and growth prospects. In doing so, however, they tend to overlook the risks associated with having such a concentrated investment in a single company—not to mention the double risk of having that be the same company that’s also the source of their monthly income.

Familiarity bias can also manifest itself in how you allocate your investments between asset classes or sectors. Maybe you’re uncomfortable venturing into an asset class where you incurred significant losses in the past—despite knowing that overconcentrating in a single stock, sector, or asset class increases your overall portfolio risk. The result can be amplified losses during a market correction, wide day-to-day swings in the value of your portfolio, and missed opportunities to earn a greater long-term return on your investment. 

What’s the best way to overcome these instincts to stick with what’s familiar? Adhering to a thoughtful, comprehensive financial plan that you and your Janney Financial Advisor design together can make a huge difference—easing any anxiety you may have about venturing into unknown areas of investing. 

Framing bias

This is what occurs when you fail to see the inherent bias in the way information is being presented to you. For example, you may be inclined to place far greater importance in a ‘breaking news’ story that leads off a broadcast—even though other information buried deeper in the broadcast and presented without much fanfare actually has far greater significance.

Framing bias represents a cognitive limitation that similarly influences the way we perceive news about the economy and financial markets. And it’s not just about the emphasis placed on the relative importance of information; it’s also about how it’s presented, which often leads us to make decisions without full information and all the necessary context. 

One way to avoid framing bias is to consider multiple perspectives. Filtering emotionally charged news with facts and opinions from a variety of sources (especially opposing viewpoints) may help diminish the risk of a misguided reaction to headlines and hype. Long-term financial planning can provide additional objectivity—keeping your portfolio closely aligned with your goals no matter how specific individual investments are being framed. 

Mental accounting 

The different emotions you attach to how you budget and categorize expenditures, income, and savings is known as mental accounting. When it comes to personal finances, people often create a cognitive distinction between their willingness to draw on their income versus their savings for spending purposes. 

Similarly, mental accounting often comes into play in the investment distinction we often draw between yield (income) and capital appreciation (growth). Investors who want their assets to generate money for their ‘mental spending account’ tend to have a bias towards investments that generate yield. Whereas investors who want their assets to boost their ‘mental savings account’ will typically show a bias towards growth-oriented investments. 

Possibly, it can also help explain the recent ‘search-for-yield’ phenomenon. In light of current monetary policy driving a sustained low-yield environment, income investors find themselves in a dilemma: having to choose between historically low yields offered by high-qualify fixed income investments; or chasing higher yields through riskier bonds and/or dividend-paying stocks. 

Even though total return is technically the aggregate sum of both yield plus capital appreciation (or depreciation), in reality many investors put yield and capital appreciation into separate mental accounts—viewing the former as spendable cash flow, and the latter as underlying principal value that’s earmarked for long-term goals.

To avoid counterproductive outcomes from misguided mental accounting, try to stay focused on ‘total return’ from all your combined investment and savings accounts. Allow the financial planning process to do what it does best—identify the optimal strategy to both accumulate and draw-down wealth in a way that meets current income needs while maximizing future growth opportunity.

Overcoming your biases

Try to stay focused on long-term goals instead of short-term market movements. Avoid becoming over-saturated with financial news (yes…that means turn off the news) which can serve to fuel emotionally driven decisions. And maintain a steady ongoing dialog with your Janney Financial Advisor. He or she can help address your concerns, frame possible actions in a way that allows you to remove emotion from the equation, and keep you focused on long-term goals rather than short-term distractions.

Biases aren’t always a bad thing. But the better we understand how they can slant our perceptions and influence our actions, the easier it becomes to avoid their excesses and keep our financial plan on track.

¹ “How Most Investors Get Their International Stock Exposure Wrong,” Forbes, August 2019

Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.