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Course 508
Behavioral Pitfalls, Part 2

Introduction

Portfoilo 507 introduced the concept of behavioral finance -- the study of the psychology and the behaviors of investors, particularly the mistakes that they make. Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behavior might move the market.

That course covered five behaviors that investors exhibit. This course covers five additional behaviors that can subvert investment performance.

Pitfall: Anchoring

Ask New Yorkers to estimate the population of Chicago, and they'll anchor on the number they know--the population of the Big Apple--and adjust down, but not enough. Ask people in Milwaukee to guess the number of people in Chicago and they'll anchor on the number they know and go up, but not enough. When estimating the unknown, we cleave to what we know.

Investors often fall prey to anchoring. They get anchored on their own estimates of a company's earnings, or on last year's earnings. For investors, anchoring behavior manifests itself in placing undue emphasis on recent performance since this may be what instigated the investment decision in the first place.

When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it. We may cling to subpar companies for years, rather than dumping them and getting on with our investment life. It's costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.

Pitfall: Confirmation Bias

Another risk that stems from both overconfidence and anchoring involves how we look at information. Too often we extrapolate our own beliefs without realizing it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favorably.

For instance, if we've had luck owning a particular brand of cars, we will likely be more inclined to believe information that supports our own good experience owning them, rather than information to the contrary. If we've purchased a mutual fund concentrated in health-care stocks, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.

Hindsight bias also plays off of overconfidence and anchoring behavior. This is the tendency to re-evaluate our past behavior surrounding an event or decision knowing the actual outcome. Our judgment of a previous decision becomes biased to accommodate the new information. For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. This type of "knowledge updating" can keep us from viewing past decisions as objectively as we should.

Pitfall: Mental Accounting

If you've ever heard friends say that they can't spend a certain pool of money because they're planning to use it for their vacation, you've witnessed mental accounting in action. Most of us separate our money into buckets--this money is for the kids' college education, this money is for our retirement, this money is for the house. Heaven forbid that we spend the house money on a vacation.

Investors derive some benefits from this behavior. Earmarking money for retirement may prevent us from spending it frivolously. Mental accounting becomes a problem, though, when we categorize our funds without looking at the bigger picture. One example of this would be how we view a tax refund. While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as "found money" to be spent more frivolously. Since tax refunds are in fact our earned income, they should not be considered this way.

For gambling aficionados this effect can be referred to as "house money." We're much more likely to take risks with house money than with our own. For example, if we go to the roulette table with $100 and win another $200, we're more likely to take a bigger risk with that $200 in winnings than we would if the money was our own to begin with. There's a perception that the money isn't really ours and wasn't earned, so it's OK to take more risk with it. This is risk we'd be unlikely to take if we'd spent time working for that $200 ourselves.

Similarly, if our taxes were correctly adjusted so that we received that refund in portions all year long as part of our regular paycheck, we might be less inclined to go out and impulsively purchase that Caribbean cruise or flat-screen television.

In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance, or realized capital gains.

Quiz 508
There is only one correct answer to each question.

1 Placing undue emphasis on recent performance is an example of
a. Anchoring
b. Framing effect
c. Herding
2 Confirmation bias is
a. Anchoring on what we know when estimating the unknown
b. Treating information that supports what we already believe, or want to believe, more favorably
c. Separating our money into buckets
3 Which statement is true?
a. Mental accounting, such as separating money into buckets, is always dangerous
b. Investors should take risk with “house money”
c. Investors can derive some benefits from mental accounting
4 What is an example of the framing effect?
a. Following a stock tip under the assumption that others have more information
b. Using a meaningless benchmark to make a financial decision
c. Investing a tax return on a Caribbean vacation
5 Following a stock tip, under the assumption that others have more information, is a form of
a. Mental accounting
b. Herding behavior
c. Anchoring
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