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

Part one of this behavioral biases series 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%. In part two, we examined three other behaviors that 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.

In this latest article we delve into three more investor behaviors—overconfidence, anchoring, and herding—and the adverse impact each can have on our rational investment decision-making.

Overconfidence

Called “the most significant of the cognitive biases” by Nobel Laureate Daniel Kahneman,¹ overconfidence refers to our almost inherent certainty when it comes to predicting future events—along with the inevitable surprise whenever we’re proven wrong (which occurs far more often than we expect).

Look no further than a much-cited behavioral research study which asked individuals to forecast something they were 98% confident would occur (in other words, a near certainty). Yet between 30-40% of the time, their forecasts failed to materialize!²

Overconfidence often causes us to view our investment decisions as much less risky than they actually are. And it can lead us to drastically overestimate the returns certain assets will deliver (such as expecting a 6% yield from a government bond, or expecting a high-flying stock that soared more than 100% during the past year to continue doing the same going forward).

While it’s true that this innate overconfidence helps us avoid inaction (which can also lead to poor financial outcomes), developing a better understanding of our forecasting limitations tends to make us less dogmatic and more accepting of contrary information—two qualities that greatly enhance the likelihood of a positive outcome.

A thoughtful financial plan is one of the best ways to mitigate overconfidence—helping you to prepare for an outcome that seems reasonably likely, while building enough of a buffer just in case reality falls short of your expectations. This includes setting performance goals that consider long-term historical returns of various asset classes as well as their correlations.

According to Benjamin Graham, the father of value investing and author of The Intelligent Investor, a plan encourages you to build a ‘margin of safety.’ For example, by purchasing a stock when its market price is below its intrinsic value you’re applying a margin of safety. The discounted price creates a cushion in case your original estimates were biased.

Anchoring effect

Suppose someone asks you what you think the price of Apple stock will be a year from now? You’ll probably start by looking at the current price of around $150/share and build your assumptions from there. It’s a simple example of ‘anchoring’ in action—making judgments based on some sort of initial information or an initial reference point. Even though the stock might be vastly overvalued or undervalued, you lock on to the current price and build all your future assumptions from that anchor.

Not only does anchoring cloud our judgment, it often prevents us from processing new information that could help us make more accurate decisions. And the more relevant the initial information seems, the more likely we are to cling to it.

Studies have shown how anchoring tactics often entice us to make purchases. For example, if you’re looking to spend $60 on an item you might not buy the item if it costs $75. If, on the other hand, the item is priced at $100 but on sale for 25% off, you’re more likely to purchase. The cost of the item is the same $75, but you’ve anchored your decision based on a perceived higher $100 value.³

This same principal can impact our investment decisions as well. An investor might look at a stock that’s declined in price as a ‘bargain’ solely based on it now being less expensive. But there may be a host of other factors they’re overlooking. The company’s growth prospects may have dimmed. A new competitor may have entered the market. Or other factors may be threatening future profitability.

By anchoring ‘fair value’ exclusively to the purchase price, rather than information about underlying fundamentals, investors often take on far greater risk than necessary. And while a more disciplined approach to investing doesn’t protect you from losses, mistakes are generally fewer when portfolios are built on solid principles and up-to-date information.

Herding

Legendary investor Sir John Templeton once said: “To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.” Unfortunately, few individuals are able to consistently live up to that lofty ambition. Rather, we tend to be ‘pack animals’ with a herd mentality—reluctant to go against the crowd even when we know it’s probably in our best interest.

Herding provides a sense of comfort and protection. Better to be wrong together than risk being wrong all by yourself and ridiculed by the herd. In the investment world, this behavior is what drives market frenzies—creating ‘bubbles’ due to people’s FOMO (fear of missing out), and panic sell-offs as everyone jockeys for a seat on the lifeboat.

The current phenomenon of investing in ‘meme stocks’ is but the latest example of herd behavior. This craze involves investors who are encouraged by online forums and social media narratives to pile into a stock with a compelling, yet fundamentally challenged, story. As the stock advances, other investors jump on the bandwagon in order to own what everyone is talking about.

Look no further than last year’s stratospheric rise of GameStop from a price of around $3/share in April 2020 to nearly $350/share in January 2021—all without any underlying fundamental reason. But experience tells us that the risk in these situations is equally stratospheric, and generally ends unfavorably for the majority of investors who made an impetuous buying decision only to find out too late that all the buzz was smoke and mirrors.

What’s the best way to avoid herding bias? Stay in your lane by adhering to a disciplined investment approach, stay committed to your financial plan and the long-term goals you’ve set, and conduct regular periodic reviews with your Janney Financial Advisor to reset expectations and re-examine your portfolio risk.

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.

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.

¹ Kahneman, Daniel (2011). “Thinking, Fast and Slow.” Farrar, Straus and Giroux.

² Montier, James (2007). “Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance.” John Wiley & Sons.

³ Simonson, Itamar; Drolet, Aimee (2004). “Anchoring Effects on Consumers’ Willingness to Pay and Willingness to Accept.” Journal of Consumer Research 31 (681-690).