Money Scripts: The Stories We Tell Ourselves in Order to Live, Save and Spend
Discover the hidden influences on your financial decisions, and how they impact saving, spending and investing.
Welcome back to our “ABCs of Behavioral Biases.” Today, we will get started by introducing you to four self-inflicted biases that knock a number of investors off-course, which are anchoring, blind spot, confirmation and familiarity bias.
What is it? Anchoring bias occurs when you fix on or “anchor” your decisions to an initial reference point, whether or not it is a reasonable one.
When is it helpful? Setting an anchor point can be helpful when you are negotiating a sales or business transaction, such as buying a car or asking for a raise. As the late Nobel laureate Daniel Kahneman and co-authors describe in Noise, anchoring is “often deliberately used in negotiations. Whether you are haggling in a bazaar or sitting down for a complex business transaction, you probably have an advantage in going first, because the recipient of the anchor is involuntarily drawn to think of ways your offer could be reasonable.”
When is it harmful? In investing, people often anchor on the price they paid when deciding whether to sell or hold a security.
“I paid $11/share for this stock and now it’s only worth $9/share. I’ll hold off selling it until I’ve broken even.”
Evidence-based investing informs us that the best time to sell a holding is when it is no longer serving your ideal portfolio, as prescribed by your investment plans. What you paid is irrelevant to that decision, so anchoring on that arbitrary point creates a dangerous distraction.
What is it? Blind spot bias occurs when you can objectively assess others’ behavioral biases, but you cannot recognize your own.
When is it helpful? Blind spot bias helps you avoid over-analyzing your every imperfection, so you can get on with your one life to live. It helps you tell yourself, “I can do this,” even when others may have their doubts.
When is it harmful? It is hard enough to root out all your deep-seated biases once you are aware of them, let alone the ones you remain blind to. In “Thinking, Fast and Slow,” Kahneman describes (emphasis ours): “We are often confident even when we are wrong, and an objective observer is more likely to detect our errors than we are.” (Hint: This is where second opinions from an independent advisor can come in especially handy.)
What is it? We humans love to be right and hate to be wrong. This manifests as confirmation bias, which tricks us into being extra sympathetic to information that supports our beliefs and especially suspicious of, or even entirely blind to, conflicting evidence.
When is it helpful? When it’s working in our favor, confirmation bias helps us build on past insights to more readily resolve new, similar challenges. Imagine if you otherwise had to approach each new piece of information with no opinion, mulling over every new idea from scratch. While you would be incredibly open-minded, you would also be insufferably indecisive.
When is it harmful? Once we believe something, we want to keep believing it. To remain convinced, we will tune out news that contradicts our beliefs and tune into that which favors them. We will discount facts that would change our mind, find false affirmation in random coincidences, and justify fallacies that we would otherwise recognize as inappropriate. And we will do all this without even knowing it is happening. Even stock analysts are influenced by confirmation bias.
What is it? Familiarity bias is another mental shortcut we use to more quickly trust (or more slowly reject) an object that is familiar to us.
When is it helpful? Do you cheer for your hometown team? Speak more openly with friends than strangers? Almost always order the same food at your favorite restaurant? Congratulations, you are making good use of familiarity bias.
When is it harmful? Considerable evidence tells us that a broad, globally diversified approach best enables us to capture expected market returns while managing the risks involved. Yet studies like this one have shown investors often overweight their allocations to familiar vs. foreign investments. We instinctively assume familiar holdings are safer or better, even though, clearly, one investor’s local market is another one’s foreign exchange. (PS: We also tend to be more comfortable than we probably should be bulking up on our employer’s company stock.)
Ready to learn more? In the next installment of this series, we will continue through the alphabet, introducing a few more of the most suspect financial behavioral biases.
This post was written and first distributed by Wendy J. Cook.
DISCLAIMERS
This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.
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Discover the hidden influences on your financial decisions, and how they impact saving, spending and investing.
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