Basic Instincts: Psychological Bias in Decision-Making
by Randy Kaufman, with research assistance from Dustin Lowman
In 2002, a dear friend gave me a book that would change my life: Fooled by Randomness. It was my introduction to the biological underpinnings of human decision making, although I already had a sneaking suspicion that the “rational man” I studied in my economics classes in the 80s was more myth than fact. I experienced a jarring epiphany, understanding for the first time that I could not possibly be a good financial advisor without understanding how humans make decisions, financial and otherwise.
For that reason, I became an ardent student of psychology, history, philanthropy, and, of course, planning when I became a wealth advisor. These topics intersect in one exciting field of study: behavioral finance. Behavioral finance, which is really not finance at all but rather psychology, examines how social, cognitive, genetic and emotional factors influence the decisions we make every day.
Terry Burnham explains in his behavioral finance classic, Mean Markets and Lizard Brains:
We have brains that worked well to solve ancestral problems. Difficulties arise when we take those ancestral instincts to unnatural environments. And there is no more unnatural environment for a human brain than a financial market.
In modern markets, humans are fish out of water. However, our seemingly irrational behaviors are actually rather predictable and systematic. By understanding those behaviors that influence decision-making, I strive to become a better investor, advisor, and human being.
Humans (and Markets) Are Not as Efficient As We Think
Behavioral finance is best understood in the context of a dominant (yet arguably faulty) market theory: the Efficient Market Hypothesis. It was the prevailing theory when I majored in Economics in the dark ages of the 1980s, and has only recently been challenged. According to this theory, major financial markets reflect all relevant information at a given time, and all people tend to act rationally. If the Efficient Market Hypothesis is correct, then investors are rational, the market price is always right, and people are strong-willed enough to make the right economic decisions.
Yet in the de facto labs of our offices and homes, there is incontestable evidence that people are prone to making irrational decisions about important issues in their lives, be it what they eat, how much to exercise, when to sell a stock, how to evaluate a charity, or whom to choose as a life partner. While these behaviors may seem irrational when evaluated against our modern needs, they certainly weren’t irrational when our species was more primitive, and faced with mere survival pressure. Many posit that they are the very behaviors that enabled our species to survive the plains of Africa, and therefore, extremely rational. But unfortunately, even though our circumstances have changed dramatically our brains have not kept up, and they can cause us to make decisions (or take actions) that appear irrational under modern circumstances.
Five Pesky Behavioral Biases Explained
Luckily for us, there are scientific explanations behind our periodic irrationality. To cope with life’s myriad complexities, people create mental shortcuts or “rules of thumb” (called “heuristics” by psychologists). Heuristics help us form judgments and make decisions. Though often useful and accurate, heuristics lead to cognitive biases, which may cause us to deviate from logic in our decision-making. Dan Ariely, one of my favorite authors on this topic, wisely says: “Even the most analytical thinkers are predictably irrational; the really smart ones acknowledge and address their irrationalities.” I resemble that remark of course, often falling into the predictably irrational category. But, by understanding that, I’m able to make better decisions for myself, and coach my clients as well.
Since the complete catalog of established heuristics is far too vast to explore in this article, I’ll focus today on five particular favorites of mine, which affect people in two areas most near and dear to my heart: investing and philanthropy.
#1 — Prospect Theory asks, “Do you fear losing more than you crave winning?”
Prospect Theory posits that people are much more distressed by losses than they are pleased by gains. A simple experiment proving this has been recreated in many an Econ 101 classroom to the same effect. Participants are invited to play a game in which they have to pay $100 if they lose. They are asked how much money they would have to potentially win into order to compete. In other words, how much would they need to win in order to risk losing $100? The experiment consistently reveals that people generally need an upside of $200-$250 (or about 2x the potential losing amount) to risk losing $100.
These findings explain the dozens of distress calls I received in 2008, as well as the many clients in need of counsel throughout the many shocking events since, and now, the COVID-19 ups and downs. Loss aversion has been the clear source of anxiety surrounding these dips, as headlines have blared constantly changing messages about the markets. Since the beginning of 2020, the Dow Jones (to use one example) has indeed fallen, but at a much less precipitous angle than its initial decline. From Feb. 19 to March 23, it fell from 29348.03 to 18591.93, but has since recovered to levels comparable with this time last year. As you might imagine, many fewer clients have called to share their happiness.
Behavioral finance enthusiast that I am, I recognize that both of these responses were predictable. Understanding clients’ natural tendencies to fixate on losses prepared me to help them make better decisions, based on their goals, lifestyle and assets, during such periods of volatility.
#2 — Framing asks, “Would you drive five blocks to save $25?”
Framing is another heuristic I see often in myself, in my clients, and always in contractors and real estate agents. The way a question or problem is described as a great effect on how people will answer or react.
A classic example is to think about buying a lamp for $100. If you hear the same lamp is on sale five blocks away for $75, would you drive the five blocks to save $25? Most of us would. Alternatively, after you’ve spent an hour negotiating a car purchase for $35,000, would you drive five blocks for the same car on sale for $34,975? This scenario also saves you $25, but fewer people would bother to save $25 on a $35,000 purchase. Last time I checked, $25 is $25. If you would work to save $25 on the lamp, you should work to save $25 on the car.
Two well-known behavioral economists, Taleb and Goldstein, also studied framing in the context of investment risk. They discovered that when presented with nearly identical investments, investors are more willing to take greater risks if the risk is described as being spread out over a long time period.
A 20% drop in a portfolio in 2008 was awful, and a 10% drop in a portfolio this past March was nothing less than gut-wrenching. But if you expand your scope to the past two, three, and five years, you may find that its performance over time presents a more optimistic outlook than if you were to focus solely on performance during narrow periods of extreme market downturn.
#3 — Anchoring asks, “Are you sometimes fixated on irrelevant information — like what your house was worth last year?”
Anchoring is another heuristic I find to be prevalent. With anchoring, a person focuses on one piece of information when making a decision. This piece of information may or may not be relevant to the situation. How many people focus on the price of a stock at the time it was purchased, and, even after a decline, refuse to sell the stock until it reaches that price again? A stock’s purchase price is totally irrelevant to its current value, of course. But remember Enron, Lehman, and countless other examples wherein investors anchored solely on a purchase price, then rode a stock to zero? Jason Zweig in his brilliant book The Little Book of Safe Money sums this up brilliantly:
You must resist the pull of anchors like these. A stock is not cheap or expensive merely because its price is below or above a particular number. It is cheap or expensive only in relation to the fundamental value of the underlying business, which has nothing to do with whether the share price is near an anchor. If you find yourself getting excited over any investment based purely on its price, you’re anchoring. Pull the hook out of your head and start over, focusing on the value of the business instead.
#4 — Mental Accounting asks, “Where is the forest? Where are the Trees?”
Another common heuristic, mental accounting, is the common tendency to put money into different mental buckets. Consider those who have money saved for emergencies (a rainy day fund) but keep high-interest credit card debt outstanding. Mental accounting is one reason lottery winners usually spend their winnings within a few years and often end up worse off than before, if not completely bankrupt. Lottery winnings (or inheritances, which are far more prevalent) are somehow considered to be different from earned income.
You can embrace this bias and use it to your advantage. In 2008, and now again with COVID and huge election stressors, I have encouraged clients who were convinced the world was coming to an end to put aside enough cash and bonds for a few years of living expenses — and to stop thinking about their stock portfolio. This helped them — and me — get through one of the most difficult times in my investing career (and my personal life).
For other clients, who refuse to take money out of their portfolio once invested, and therefore deny themselves certain experiences (you know who you are and I’m among them), I suggest setting up a cash account with an appropriate name (Philanthropy; Big Trip; Fun; Obscene Dog Expenses), harkening back to the old trick employed by our grandparents — money jars or envelopes.
#5 — Overconfidence asks, “Are We Living in Lake Wobegon?”
Almost all of us display another behavioral finance heuristic — overconfidence. If you ask a room of people whether they consider themselves to be above-average drivers, typically 80% of those asked will raise their hands. Academics have run studies in which students were asked to rate their own ability to “get along with others.” A statistically insignificant number — less than 1% — rated themselves as below average. Furthermore, 60% rated themselves in the top 10%, and one-fourth of respondents rated themselves in the top 1%. Also, hilariously, one survey found 80% of respondents claiming they were above average in bed, with only 5% saying they were below average.
Overconfidence no doubt helped us to survive the dark ages, but it is a dangerous tendency when it comes to investing. It is astounding how many people think they can be better investors than trained money managers, especially when it comes to market timing, something that even the most astute investors (e.g., Warren Buffett) admit they cannot do.
Overconfidence also leads to increased trading — which is usually a losing strategy. Even if an investor chooses correctly most of the time, any gains are quickly eaten away by costs associated with trading. This is one reason I’ve always promoted diversification as the optimal allocation for achieving goals and tolerating risks.
Why These Questions Matter
Studying behavioral finance helps us rein in some of our own tendencies. It also helps us better understand our clients, friends and family members. It is particularly valuable to be familiar with the instincts and behavioral traps that affect how people make decisions.
I leave you where I started, a quote from another one of my favorite authors on this topic, Terry Burnham:
Because our instincts are exactly out of sync with financial opportunity, markets can be mean. However, it is the very irrationality of markets that provides the opportunities to make sweet profits. Financial success is based on using emotional intelligence to shackle the lizard brain. Fortunately, emotional intelligence can also be increased by diligence, introspection, and discipline. Therefore, any investor willing to work to understand and tame the lizard brain can transform mean markets into money and satisfaction.
If you found this topic of interest, please check out my book list, as well as my collection of valuable quotes. As always, questions or comments, and definitely stories about your own experience in this area, are welcome.
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