In last week’s blog, Heath pointed out the tendency of people to base investment decisions on irrelevant facts or reference points. In the field of behavioral finance, this is known as anchoring. Heath provided a great example of anchoring: basing an estimate of the number of doctors in London on the last four digits of your phone number. In the world of investing, another example is the tendency of investors to hold on to bad investments because they are anchored to their original purchase price, even if the investment has no hope of returning to that level and should be sold. Clearly, this behavioral bias has the potential to hurt the investor if not recognized.
This week, I want to introduce two more behavioral biases: hindsight bias and overconfidence. Hindsight bias occurs when a person believes, with the benefit of hindsight, that a past event was predictable and obvious, even though the event could not, in fact, have been reasonably predicted. The most vivid example is the 2008 financial crisis. Today, you will hear your golfing buddies and market pundits alike claim that they “saw it coming,” but the Chairman of the Federal Reserve, the Treasury Secretary and the CEOs of virtually every major bank in the country didn’t anticipate the magnitude of the ’08 financial crisis. With hindsight, everything is 20/20.
Hindsight bias is attributed by psychologists to our need to see order and patterns in a chaotic world. We want to simplify the world around us by finding links between cause and effect. The problem is that if those links are based on hindsight bias (and are, therefore, erroneous), they may lead to yet another bias: overconfidence.
Overconfidence is overestimating our ability to perform a particular task. Ask a room full of people how many consider themselves better-than-average drivers. Well over half of the people in the room will raise their hands, but we know that only 50% of the drivers can be better than average.
In the world of investing, overconfidence can cause investors to trade more frequently (based on the “patterns” they’ve identified due to hindsight bias) and make buys or sells based on the belief that they are better than the average investor at picking investments. In reality, research suggests that people who trade more frequently earn, on average, less than the market.
Avoiding behavioral biases is critical to successful long-term investing. Much of the value we hope to create in any client relationship is to help them identify when they may be falling prey to these types of biases and avoid making investment decisions that they may later regret.