Equity Compensation: Big Opportunities, But Beware the Risks
Equity compensation can provide a big financial boost, but it is important to manage it by balancing potential risks and rewards.
So many financial behavioral biases, so little time! Today, let’s take a few minutes to cover our next batch of biases in overconfidence, pattern recognition and recency.
What is it? No sooner do we recover from one debilitating bias that our brain can whipsaw us in an equally damaging but opposite direction. For example, we have already seen how fear and FOMO can knock our investments off course either way. Similarly, overconfidence is the flip side of loss aversion. Once we have something, we are averse to losing it, so we will overvalue it compared to its going rate. But when we are pursuing fame or fortune, or even going about our daily lives, we tend to overestimate our odds of success.
When is it helpful? In “Your Money & Your Brain,” Jason Zweig cites several sources that describe overconfidence in action, and why it is the norm rather than the exception in our lives. “How else could we ever get up the nerve to ask somebody out on a date, go on a job interview, or compete in a sport?” asks Zweig. He adds, “There is only one major group whose members do not consistently believe they are above average: people who are clinically depressed.”
When is it harmful? Overconfidence becomes dangerous when you are investing. Interacting with other biases, such as FOMO, confirmation bias and familiarity bias, overconfidence puffs up our belief that we can consistently beat the market by being smarter or luckier than average. In reality, when it is you, betting against the trillions and trillions of other dollars at play in our global markets, it is best to be brutally realistic about how to patiently participate in the market’s expected returns, instead of trying to go for broke, potentially literally.
What is it? Is that a zebra, a cheetah or a light breeze moving through the grass? Since prehistoric times when our ancestors depended on getting the right answer, right away, evolution has been conditioning our brains to find and interpret patterns—or else. That is why our pattern-seeking impulses tend to treat even fully random events (like 10 coin flips, all heads) as a predictive pattern. “Just as nature abhors a vacuum, people hate randomness,” says Zweig, as a result of our brain’s dopamine-induced “prediction addiction.”
When is it helpful? When we stop at red lights and go on green, we are making excellent use of pattern recognition. Is your spouse or partner giving you “that look”? You know just what it means before they have said a single word. And if you enjoy a good jigsaw puzzle, Wordle play or Rubik’s Cube, you are giving your pattern recognition skills a healthy workout.
When is it harmful? Speaking of seeing red, Zweig published a fascinating piece on how simply presenting financial numbers in red instead of black can make investors more fearful and risk-averse. That is a powerful illustration of how pattern recognition can influence us, even when the so-called pattern (red equals danger) is a red herring. Is any given stream of breaking financial news a predictive pattern worth pursuing, or is it a deceptive mirage? Given how hard it is to tell the difference until hindsight reveals the truth, investors are best off ignoring the market’s many glittering distractions and focusing instead on their long-term goals.
What is it? Recency causes you to pay more attention to your most recent experiences, and to downplay the significance of long-term conditions. For example, in “Nudge,” Nobel laureate Richard Thaler and co-author Cass Sunstein observe: “If floods have not occurred in the immediate past, people who live on floodplains are far less likely to purchase insurance.” That is recency, tricking people into ascribing more importance to the lack of recent flooding than to the bigger context of being located on a flood plain.
When is it helpful? In “Stumbling on Happiness,” Daniel Gilbert describes how we humans employ recency to accurately interpret otherwise ambiguous situations. Say, for example, someone says to you, “Don’t run into the bank!” Whether you are currently floating down a river or approaching a financial institution helps you quickly decide whether to paddle harder through the rapids, or walk more slowly through the financial institution’s door.
When is it harmful? Buying high and selling low is exactly the opposite of investors’ actual aspirations. And yet, no matter how many times our capital markets have moved through their bear-and-bull cycles, recency tricks droves of investors every time. By reacting to the most recent jolts instead of remaining positioned as planned for long-term expected growth, they end up piling into high-priced hot holdings and locking in losses by selling low during the downturns. Recency gets the better of them, and their most rational investment decisions.
We are on the home stretch of our series on behavioral biases. Look for the rest of the alphabet in our next feature.
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.
Shore Point Advisors is an investment adviser located in Brielle, New Jersey. Shore Point Advisors is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Shore Point Advisors only transacts business in states in which it is properly registered or is excluded or exempted from registration. Insurance products and services are offered through JCL Financial, LLC (“JCL”). Shore Point Advisors and JCL are affiliated entities.
Equity compensation can provide a big financial boost, but it is important to manage it by balancing potential risks and rewards.
In the second part of this young investor series, we discuss three more investment concepts every young investor may want to embrace.
If you are new to investing, it can be tough to know where to get started. There is so much information and advice out there.
During this series, we have learned that our own behavioral biases are often the greatest threat to our financial well-being.