This column was first published in the Knoxville News Sentinel on December 12, 2018
We all fall into traps that have the potential to take us off track of achieving our financial goals. Some of us are more conservative with our money than we can afford, and some of us are more aggressive than we should be.
There are four distinct investor personas that classify investors by how they perceive and react to financial risk and whether they are driven by emotions in decision-making or more prone to cognitive errors.
The distribution of the population is fairly normal when it comes to these personas, with the extremes of fear and greed pulling at the fringes.
Most people fall in the middle with a moderate risk tolerance and a balance of emotional and cognitive biases.
There are dozens of biases that can affect individual investors as well as the experts, and most of us tend toward either emotional or cognitive biases.
Emotional biases stem from impulse, intuition or feelings of fear of loss or fear of missing out. Cognitive biases are due to errors in memory, faulty reasoning or information processing.
While “bias” sometimes has a negative connotation, in behavioral economics, it is just a way to describe how human behavior deviates from economic theory.
For example, we are more likely to believe that new information is true if it confirms our existing view. This is called confirmation bias, and it can distort our understanding of the facts if we are constantly processing information through the lens of prior experience and knowledge.
Another common bias is endowment effect. Humans tend to assign a higher value to things that they own than if they didn’t own them. Suppose you have tickets to a football game, and your team is on a winning streak, causing the price of tickets to spike to $500 each before the game. Do you think to yourself:
A. “I am going to sell my tickets and watch the game from home,” or
B. “How lucky that I had these tickets in hand before the winning streak. I would never pay $500 to attend the game, but since I acquired the tickets for much less, I can afford to go.”
If your answer is the latter, you suffer from endowment effect. Economic theory would predict that you would always sell the tickets for $500 if you wouldn’t purchase them for $500. Either you assign the tickets a value of $500 or you don’t. Any other choice is irrational. Most of us, however, would find ourselves in the stands cheering on our team, feeling like we got a bargain.
When it comes to investing, loss aversion is a bias that can cause people to make poor investment decisions.
Research shows that most of us experience the pain of losses twice as much as the positive feeling we get from gains. This asymmetry can cause us to hold onto losing positions longer than we should to avoid realizing the loss. It is also closely tied to regret aversion, which can cause us to take less risk than we should to avoid feeling the pain from a loss in the future.
Are you more prone to emotional decisions, or do you fall prey to some of the more cognitive errors? Just being aware of your behavior can help overcome some of these pitfalls.
Special thanks to Miranda Carr, CFA, and Wealth Strategist for her contributions to this column.