How Biases Affect Investor Behavior

By Carl Lachman, CFP®, MBA

Orange County Adults Are Still Influenced By Junior High Peer Pressure

In Orange County, California, we never leave junior high in some ways. When we were 14 years old, our friends and other students had a huge sway on our behavior through peer pressure. We really cared about what other teenagers wore, talked about, listened to, and how they spent their free time. We often made decisions to do the same things so we would fit in. As adults, we still want to fit in.

It’s a Natural Condition and It Is Everywhere

We’ve matured and moved on from junior high, right? Not so fast. This peer pressure influence that others have on our behavior continues to shape us as adults and is rather obvious in Orange County—our homes, cars, money, clothes, food, etc. It is so obvious that there are “reality” television shows that demonstrate the extreme examples of it in OC.

Wanting to fit in is a natural, innate, instinctual part of the human condition. Some people may be more contrarian in their perspective to see another way, and others may like to do the opposite of what they see others doing— but most of us are stuck with this primitive drive to fit in with those around us.

Why Do We Want to Fit In?

It comes down to a hard-wired, biological need for self-preservation. We want to survive. We want to be safe. We innately know that we are safer in the large group. The crowd can organize itself for defense. The loner will get picked off first.

We’re like sheep. Those that are in the herd are safe from the wolf pack, but those that wander off by themselves are easy for the wolves to have for dinner. This is known as our herding bias. If we are in the herd, our biologically innate wiring tells us that we will survive.

Other Biases We Had in Junior High

When we would do research for a position paper in junior high, we would latch on to the first thing we found in the library or on the internet that agreed with our opinion. Confirmation bias. When we were successful as a teenager, we often attributed our success to our skill and knowledge, but really it was just luck and chance. Self-attribution bias.

We ate at the same fast food restaurant again and again. Familiarity bias. We told our friends what they did wrong and mocked them for being so dumb, but really the outcome could not have been so easily predicted at the time. Hindsight bias.

When we finally saved enough money, we bought the same clothes that were popular, only to find out that when we finally wore them, everyone else had moved on to different clothes. Trend-chasing bias. We may have done well on countless assignments, but we forgot about that and thought the world was falling apart the first time we received a lousy grade. Recency bias.

As Adults, Our Investor Behavior Is Affected by the Same Biases

Unfortunately, we are wired as humans to our investing disadvantage. All these biases we had in junior high we still have as adults, and they cause us to be poor investors.

We invest in the same stock that our friends are buying (herding). We do investment research by only reading investing articles that agree with our predictions (confirmation). We believe we are brilliant investors when we pick a winner, when it was really luck (self-attribution). We really like tech stocks for our portfolio but miss the correlation to the fact that we work in a tech company (familiarity).

We clearly see after the fact what we did when the economy tanked and we invested the wrong way (hindsight). We get anxious by the 5% fall in our portfolio this month, forgetting that we are up 17% in the last year (recency). We invest in the European stock index because it is up 34% in the last two years (trend-chasing).

The study of these biases is the subject of behavioral finance.

Can We Get Away from These Biases?

Not really. They were with us as teenagers, and they are clearly with us as adults. One way or another, these biases are wired into our biological behavior, and getting rid of them is too tall of an order. Rather, we need to approach investing with an acknowledgement of these biases and try to find ways, frankly, to save us from ourselves.

Biases Are More Easily Seen in Others

It’s true that it is easier to see the biases in others, rather than see them in ourselves. Again, this is just part of being human. So, if we can get the help of someone else to point out when we are falling prey to bias in our investing, we’ll make better decisions and avoid a lot of mistakes.

Our Accountability Self-Option

The first way to get accountability is hard, but doable: We can hold ourselves accountable. If we make a financial plan and write it down, then that plan can hold us accountable. When the stock market is going down, we can refer to our plan and do what we said we would do when the market goes down.

It takes discipline, but it can work. We make much better decisions in calm and undistracted times, and if we write down our plan then, it will help us avoid our biases in the storms of financial market upheaval.

Our Accountability Delegation Option

We can delegate accountability for our investments with target date or allocation mutual funds. The fund managers will keep our portfolio on track in the ups and downs of the financial markets and invest in a diversified way for us, if we invest in mutual funds that have a fixed target retirement date or a stated risk preference allocation strategy. We remove our biases by allowing these mutual fund managers to make the investing decisions for us.

Our Accountability Hire Option

Our third option is to pay an investment advisor to give us independent advice without conflicts. It doesn’t help to hire someone who sells financial products and gets paid by commission, since that causes their advice to be biased. We’re trying to avoid our biases and find an advisor who doesn’t have them, either.

To find an investment advisor who doesn’t receive a sales commission, search for “fee-only” financial advisors who are paid only for the advice they give and who don’t sell products.

Investor Behavior Biases Are Here to Stay

Since the biases that affect our investor behavior are part of our biology, we can’t rid ourselves of them. Rather, we must come up with a different strategy of combatting them. Using a form of accountability is a realistic and effective solution.

Schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.

Carl Lachman, CFP®, MBA