How Behavioral Biases Can Skew Your Perception of Risk
It is in our behavioral nature to assess risk based on identifiable examples, not only can that mindset skew decision making, it can leave us vulnerable to risks we are not as familiar with and closed off from opportunities we may believe to be too risky. These things coupled together do not make for clarity of thought when making investment choices.
Availability Bias or Availability Heuristic is “a mental shortcut that relies on immediate examples that come to a given person’s mind when evaluating a specific topic, concept, method or decision.”
As we live in the aftermath of the Great Recession, though the strides that the markets have taken between then and now have been impressive, investors maintain an availability bias that “safe is good” and “risky is bad.” Unfortunately, that leaves investors with quite a dilemma.
With interest rates low and fixed-income investments growing very slowly, investors in “safer” bonds may feel less vulnerable, but it isn’t getting them closer the their goals. The lingering perceptions of a dire market environment (a clear indication of availability bias) may be causing people to view investment opportunities through a negative lens making it difficult for people to mentally justify taking on investment risk despite the minimal returns on perceived “safe” investments.
How to Avoid Availability Bias
The example given above was of the Market Crash of 2008-09 and the subsequent Great Recession, perhaps because it has had the greatest impact on the largest number of investors in recent history. And, let’s preface this by saying that it was a very big deal. People lost and they lost big time. Availability Bias is a defense mechanism that people have within their psyche to protect them from repeating past mistakes and making poor decisions. That being said, our human psyches are not built for investing, and, to make wise investing decisions, is to turn off the transmitters that our brains bombard us with when it comes to taking risk.
The best way to avoid Availability Bias and other forms of behavioral investing biases is to understand that investing is about looking at the facts, not reacting to the latest news, being prudent, using research, and understanding that opening one’s self up to a certain degree of risk is the surest way to grow assets over time and outpace inflation.
Here are some facts:
Over the course of the past 90 years we have experienced recessions, world wars, natural disasters and market crashes and still, the markets have worked to grow wealth over the long term.
In 1916 a quart of milk was $0.09. Had you taken that same $0.09 in 1926 and put it under your mattress until 2016, it would have bought you 7 tbsp. of milk. This is inflation. Had you invested it in small cap stocks in 1926, it would be worth about $2,340 by 2016. That is 16,380 tbsp. of milk!
The Role of an Advisor
A fiduciary advisor can act as a behavioral coach as well as an expert in the field of portfolio management and financial planning. There may be instances where you have strong feelings, or fears, or intuitions about where and how your money should be invested. A good advisor will listen to you and then, that advisor, will help develop a strategy that is based on good decisions, help you to understand where some of your perceptions may need redirection and bring you and your investment plan to a place where your goals are positioned to be met.
For many investors who are doing it on their own or working with a brokerage, who might be feeding the biases or simply doing what is asked of them, the fears and preconceived notions they might have about certain investment options end up becoming self-fulfilling prophecies. They make not-so-great investment decisions possibly because of behavioral biases and the outcome is not great--and the cycle repeats itself.
Working with an advisor who understands the science behind investing and the complexities of why we invest the way we invest can be a valuable step in accomplishing your goals and finding peace-of-mind in your planning process. For more information on how to build an investment plan and portfolio that positions your assets to outpace inflation and fund your goals contact This email address is being protected from spambots. You need JavaScript enabled to view it..
Sources:
https://my.dimensional.com/csmedia/cms/about_dimensional/2014/03/adiffere/A_Different_Way_to_Invest.pdf
http://www.businessinsider.com/the-availability-bias-is-driving-investor-decisions-2012-10
https://erm.ncsu.edu/library/article/avoiding-confirmation-bias-in-decision-making
http://www.cbsnews.com/news/investment-decisions-how-to-avoid-availability-bias/
http://www.cbsnews.com/news/investment-decisions-investors-can-be-nudged-to-do-the-right-thing/