Behavioral Finance

The 7 Harmful Vices

Ron Gambassi
September 28, 2012

In his new book, Behavioral Finance and Wealth Management, Michael M. Pompian highlights seven primary biases he thinks can be keeping investors from achieving their financial goals.

Pompian polled 178 individual investors about 20 key behavioral biases.

The following ones had a greater than 50% affirmative response rate:

1)      Loss Aversion Bias: The pain of losses is greater than the pleasure of gains

Have you ever lost sleep thinking about your winning investments?

2)      Anchoring: Getting “anchored” to a price point when making an investment decision

Buying or selling at a particular price point is often a good and disciplined strategy. The key is whether the price point is part of a strategy or a figure determined out of emotion or psychology.

3)      Hindsight Bias: Believing that investment outcomes should have been able to be predicted

A lot of people missed the Apple opportunity. Stop kicking yourself.

4)      Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective

Facebook anyone? The craze for that stock at the IPO far exceeded logical decision making based on traditional metrics like price/earnings ratio and the amount of revenue they were generating.

5)      Representativeness Bias: Making current investment decisions using the result of past similar investments as a frame of reference

You had investment success with an asset that has risen steadily over the past few years. Now that same investment is overpriced by historical standards yet you want to buy more. This one is often closely related with “anchoring”.  “I think I’ll wait ‘til the price hits 100 and then sell’.  Never mind at $87 the stock has a P/E ratio of 100!

6)      Status Quo Bias: Not taking action to change one’s investment portfolio (i.e. doing nothing when prompted to do so)

‘The market is up; I think I’ll wait to get in’. ‘The market is down; I don’t want to get in now’.

7)      Regret: Past (poor) decisions affect future investment decisions

Did you buy just before the 2008 crash and become so shell-shocked you never got back in?

If so, you missed out on reversal of all the paper losses (i.e. in the S&P 500) and further gains.

Pompian also identified a series of 19 secondary biases. He asked questions of the survey respondents to determine which biases seemed to correlate in higher percentages. One such case was those with the ‘status quo’ bias had a high tendency to have ‘regret’ as their secondary bias.

He writes it this way, ‘The major implication for status quo and regret is that these biases often keep otherwise good-intentioned investors out of a market that has recently generated sharp losses or sharp gains. Having experienced losses, our instincts tell us not to invest. Yet periods of depressed prices may present great buying opportunities. And we’ve all also been guilty of cutting risk out of fear of gains evaporating only to see the markets continue to run–especially when the Fed is so accommodating’!

It’s probably too much to ask that we, as investors, not have biases. Instead, it might be best to recognize our biases and work at not letting them get in the way of achieving our financial goals.

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