The Golden Rule of Investing is “Buy Low, Sell High”. Seems rather simple and easy to follow, so why do individual investors consistently underperform market indices? Despite the simplicity of the rule, it turns out it’s difficult to implement. Countless factors impact how individuals make decisions on a daily basis, and, generally speaking, these factors often work against the desired outcome of greater investment success. Clinical bias is the term describing the mental hurdles or breakdowns in decision making. There is no shortage of these road blocks. As of 2017, there were almost 200 defined clinical biases1.
How do these biases affect investors?
Let’s start with gathering some current market information. If you research market opinions online, watch the “experts” on investment channels, or pick up your favorite investment periodical, it won’t take long to find at least one “expert” predicting each of three potential outcomes: markets will go up, down, or stay the same. This probably doesn’t come as a surprise, but those are the available options. Now, your clinical biases will determine what you do with that information. Who do you believe and what do you do about it? Does the information confirm your beliefs (confirmation bias), fit recent patterns (recency bias) or trigger fear (loss aversion)2? How you process this information and use it to make investment decisions is an interesting study in human behavior and ultimately the subsequent investment performance.
Investing is an interesting conundrum – generally speaking, we need to invest in risky assets to grow purchasing power, but we don’t like to lose. In fact, loss aversion was the starting point for a 1979 study of behavioral economics and finance. Daniel Kahneman and Amos Tversky completed the Nobel-prize winning study of how individuals responded to economic gains and losses. The study confirmed that individuals feel the impact of equivalent gains and losses in different ways. For example, a 10% investment gain doesn’t provide the same euphoric nirvana as the gut-wrenching 10% investment loss. Simply stated, they studied decisions people made and their responses to outcomes rather than assuming people always make rational choices. Turns out, individuals commonly make poor investment decisions because of the previously mentioned biases. We see this time and time again – the 1990s Dot Com and early 2000s real estate bubbles are examples. We have a desire to “fit in” or “follow” what others are doing despite potential consequences.
When you were a kid did your parents use the line, “…if Billy jumped off a bridge, would you do it too?” only to find yourself using the same line on your children?
Humans evolved over thousands of years making decisions for survival. It’s proven that we’re “hard-wired” to think this way. Today, our decisions are not necessarily survival based, but herd instinct affects our lives on a daily basis in everything from style choices to presidential elections.
What is Herd Instinct?
Herd instinct in finance is the phenomenon where investors follow what they perceive other investors are doing, rather than their own analysis. In other words, an investor exhibiting herd instinct will gravitate toward the same or similar investments based almost solely on the fact that many others are buying the securities.3
How can investors overcome Herd Instinct and other biases affecting investment outcomes?
The Vanguard Group’s Advisor’s Alpha® began in 2001 and was updated as recent as this year. The on-going study illustrates the benefits of working with an advisor to provide “wealth management through financial planning, discipline, and guidance, rather than by trying to outperform the market.”4 Working with an advisor can help navigate the challenges associated with investing and financial planning. An advisor can evaluate planning and investment options that are based on your goals and objectives rather than allowing emotions to drive your decisions.