The Psychology of Investing

Part 3 of a series on how cognitive biases affect investment decision-making.

This third part of Behavioral Finance and Investment Principles focuses on overconfidence, anchoring, and herding behaviors. Like those in parts 1 and 2, the concepts around these biases can help explain the reasoning patterns of investors and the emotions behind their investment decision-making.

Investors may be influenced by various behavioral and psychological factors. Behavioral finance combines financial psychology and behavioral economics to show how psychological influences impact investor behavior.

This series has detailed some of the many behavioral responses identified by psychologists and social theorists that serve to describe commonly experienced phenomena by investors.

Applying discipline, especially during times of great uncertainty, might help investors avoid cognitive errors. An investor can consider their own biases and overcome them through proper planning with their Financial Advisor. Together, they can create a suitable investment philosophy whereby decisions are made to align with the goals established in the financial planning process. Following this process, investors can focus on their defined plan and make the appropriate asset-allocation decisions that may meet their goals.

Overconfidence

Overconfidence has been called “the most significant of the cognitive biases” by Nobel Laureate Daniel Kahneman^*. This ubiquitous bias refers to circumstances where people are surprised more often than they expect to be. In other words, people are certain about their ability to predict.

A study conducted by researchers^† asked people for a forecast they believed would be accurate within a 98% confidence interval, or all but certain. If one were to take the other side, it would imply the individual’s prediction would be offsides 2% of the time. What did they find? The answer typically lands out of bounds 30-40% of the time. That is not to say people should allow this judgmental vulnerability to paralyze their decision-making because in my opinion this may lead to inaction that could cause severe outcomes. However, it suggests that having a greater awareness of our limitations in forecasting might help to mitigate the impact of an undesirable outcome. It might also help if one refrains from becoming so dogmatic in making prognostications that information that could change the course of the outcome is ignored.

Certainly, overconfidence might cause investors to view their decisions as less risky than they actually are. They may believe in an outcome that uses returns much higher than plausible, such as a 6% yield from a U.S. government bond purchased in the current environment when yields are less than half of that. In another instance, an overconfident investor might expect a high-flying stock that soared more than 100% during the past year to continue doing the same going forward, or they might seek a purchase and expect it to deliver a similar return over the following 12 months.

A financial plan is important for investors because it could serve to temper the guesswork around goal setting and investment expectations. Otherwise, an investor might make decisions predicated upon an unrealistic view of what can be achieved, either through savings or investment results, which could set up the risk of potentially not meeting your plan objectives.

I say plan for an outcome that seems likely, but build a sufficient buffer into it in the event something undermines it. Doing so might leave ample room to cover a lessoptimal, but not disastrous, result. Furthermore, set an investment performance goal in the planning process that considers long-term returns and the relationship between stocks and bonds.

A plan could encourage investors to build what legendary investor and author Benjamin Graham called a “margin of safety” in his book, The Intelligent Investor. For example, an investor who only purchases a stock when its market price is below its intrinsic value is applying a margin of safety—the discounted price creates a cushion in case estimates were biased.

I believe risk management is a way to overcome overconfidence bias. This may be in the form of mentally hedging (e.g., Monte Carlo analysis) to measure the confidence interval for a plan’s success within a wide range of possible outcomes.

Anchoring Effect

Anchoring^‡ is the cognitive bias that describes judgments that are built around the initial information or reference point offered. Furthermore, the degree to which a person might anchor to a particular item is heavily influenced by the salience of the information. In other words, the more relevant the information seems, the more people tend to cling to it.

In my experience, anchoring can taint judgments and prevent someone from using newly gained information that may be helpful, or more accurate, thereby impairing effective decision-making.

Studies have found anchoring tactics tend to elicit a purchase motivation based on what appears to be cheap compared to the price expected^§. For example, in retail: A shopper who only intended to spend $60 might scoff at an item priced at $100 because they consider it too expensive or beyond their budget. However, if a retailer posts a “sales” price of $75 next to the original $100 price, it seems like the item is a bargain and thus piques the shopper’s interest.

In regards to investing, I have witnessed the aforementioned metaphor at play when a popular stock that was selling for a certain price, say $60, falls to maybe $50.

Investors might view the price decline as meaning the stock is “cheaper,” insinuating that it is now more enticing to buy. However, the actual fundamentals of the company may have changed in the month or two during the stock’s price decline of $10. Perhaps the company’s growth prospects have dimmed due to a competitive threat that will likely impair its profitability, so the valuation reset only warrants the company’s share price to be around $40. Meanwhile, the investor/buyer—having seen the company doing well before and the stock price being $60 in the recent past—overlooks the updates that changed the company’s prospects and focuses only on the current share price that appears attractive. By anchoring the “fair” value to the purchase price rather than underlying fundamentals, the investor takes on greater risk.

In summary, I believe investment decisions that are made with relevant and reasonably up-to-date information may aid a disciplined investment approach. A disciplined approach to investing does not preclude incurring a loss, but mistakes could be fewer if built upon solid principles. Focusing on the long-range goals established in a financial plan could reduce the anchoring effect by raising awareness of the suitability of the investment.

Herding

Herding is evidenced in crowd psychology^¶ and is a behavior in which people react in a collective way. A person with herd mentality might adapt to the movement of the crowd even if it is contrary to their personality or character, or how they would likely behave if alone.

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.”

Easier said than done, in my opinion. For many, it might be easier, or at least more comfortable, doing what others are doing rather than making decisions independently on their own volition. The latter could possibly leave someone isolated in their view and create discomfort by way of creeping thoughts of being wrong or fear of being considered radical.

In the markets, herding occurs in frenzies that can drive a stock or market to extreme highs or lows. An acronym that has become common today is FOMO, or “fear of missing out.” This concept defines a theme where a stock, or more broadly the stock market, goes up so persistently that sidelined investors are drawn in to buy. Buying begets buying as others see the market or a stock rising relentlessly and “want a piece of the action.”

I think the current phenomenon of investing in so-called “meme stocks” offers an interesting example of herd behavior. The meme stock craze involves investors who are encouraged by narratives on social media and other channels to pile into a stock with a compelling, yet fundamentally challenged, story.

If the stock is in the midst of an advance, some investors want to imitate the buying impulse others are employing in order to own what everyone is talking about. I’ve found in my experience that the risk in these situations is it often ends unfavorably for a group of investors who made an impetuous decision in buying. Often, these investors find out too late that something changed, and the stock or market falls and improperly risk-budgeted capital is squandered.

In my opinion, investors could mitigate the cognitive bias of herding by staying in their lane and adhering to a disciplined approach to investing, staying committed to setting the goals associated with proper planning, and having regular reviews with a Financial Advisor to reset expectations and reinforce risk assessments. Altogether it may not prevent an investor from reaching to chase a crowded trade, but it might keep them focused on their plan.