Human behavior has a greater impact on financial returns than most people realize. It’s more fun, exciting, and easier to listen to investment ideas from endless YouTube gurus and Tik Tok financiers. Taking the time to understand how cognitive errors and behavioral biases impact our investment performance just isn’t as exciting as learning about the sure fire way to generate passive income for life by simply “getting into real estate” or “speculating in crypto”.
There is a difference between investment returns and investor returns, and for the most part, people (i.e. the investor) tend to get in their own way with investment performance suffering. One of my favorite Financial Planners, Carl Richards, calls this “The Behavior Gap”. He wrote a phenomenal book of the same name – which I strongly recommend.
The economy is not just charts and graphs, it is people, families, cultures, politics, and all the emotional baggage that comes with it. One of my best friends for nearly 20 years, and a client of our firm, practices professionally as a psychologist. I have been spending more and more time discussing the impact of human behavior in financial planning with him, and the deeper I dive, the more I realize how impactful our behavior is to our personal financial outcomes. While many of humanity’s cognitive shortcuts we use are essential to survival, they don’t always align with what is needed for a long term investment plan. After all, for the majority of our time on earth we were more focused on basic survival, not managing a 401k.
I want to share some of the more interesting ideas that I learn about and in proper “Common Cents” form, try to provide actionable ideas to improve your financial life.
Recency Bias – what is it and why should I care about it?:
Recency bias is a common cognitive bias that can have a significant impact on personal investing. It occurs when people make decisions based on their most recent experiences or memories, rather than considering a more broad and diverse range of information. In the context of investing, this can lead to overconfidence in recent investment successes, or an increased fear of risk following a string of losses.
The stock market is inherently unpredictable, and relying on recent performance as a guide for future investments is not a reliable strategy. The stock market may very well not act rational over shorter periods of time, but does tend to be an excellent wealth creator for those who stick with it. This makes recency bias particularly tricky for investors.
For example, let’s say that you’ve recently made a number of successful investments, and you feel confident in your ability to pick winning stocks. You might be tempted to put more of your money into the market, believing that you have a good track record and a strong understanding of how the market works. On the other hand, if you’ve recently experienced losses in the market, you might be more risk-averse and less likely to invest in the future. Recent bias is a two way street.
Addressing Recency Bias – what can you do about it?
Write down a plan & stick to it: This can help you stay focused on your goals and avoid being swayed by recent market trends. After all, who wants to have to re-draft a new investment plan if it isn’t really necessary.
Stay Diversified: This can reduce the risk of extreme loss, as different types of assets tend to perform differently in various market conditions.
Get another opinion: A qualified financial advisor can provide objective insights and guidance on your investment decisions, and can help you stay focused on your long-term goals. They can help you work through rough markets and manage not just your investment portfolio, but your behavioral portfolio as well!
In addition to seeking professional guidance, there are a few other steps you can take to avoid falling victim to recency bias:
- Educate yourself about investing: The more you understand about the stock market and how it works, the better equipped you’ll be to make informed investment decisions.
- Be patient: It’s important to remember that investing is a long-term endeavor, and it can take time to see significant returns. Don’t get caught up in short-term market fluctuations, and try to stay focused on your long-term goals.
- Avoid following the crowd: It can be tempting to follow the advice of friends, family, or financial gurus, but it’s important to do your own research and make investment decisions that are right for you.
It is a reality to acknowledge that human behavior plays a role in investment outcomes. Focus on developing systems and processes that will establish guardrails, ensuring your investment plan will not veer from course as a result of human psychology. Once you accept the powerful impact that human behavior has on your financial plan, the easier it will be to do something about it!
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA
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