What’s your problem? The oft-cited greed and fear characteristics aren’t the only emotions that get investors in a pickle. There are a whole range of behavioral biases and traits that lead to trouble.
Before you can avoid these counterproductive traits, you first need to be aware of what they are, along with your susceptibility to them. All investors – even professionals – are prone to human error.
This week on my radio program, the Index Investing Show, I spoke with Michael M. Pompian, CFA, the author of Behavioral Finance and Investor Types (John Wiley & Sons, 2012) about his latest book on this fascinating topic.
Let’s analyze some of these human traits.
Status Quo Bias (SQB)
People are generally not comfortable with change and as a result they avoid making changes even if it means improvement. The SQB investor prefers to make no choices or decisions because they view it as too risky. What they fail to understand is that even the “no decision choice”, is still a decision.
People with SQB fail to explore new investment opportunities. Additionally, they tend to keep investment portfolios that may be higher risk or not precisely match their goals. SQB is classified as an emotional disorder.
EXAMPLE: A SQB investor has the habit of owning money losing stocks or funds because they feel comfortable or familiar with those holdings.
Hindsight Bias (HB)
HB occurs when people see past events as predictors of what will happen once again. As a result, the HB person likes to extract historical data to prove the certainty of future outcomes. Unfortunately, while history sometimes rhymes, it doesn’t always repeat itself verbatim.
Here’s the problem: HB may cause investors to increase their risk by overleveraging investments that have done well in the past, but may not necessarily do well in the future. HB is a cognitive disorder.
EXAMPLE: A HB investor has the habit of owning or buying investments with good historical performance in expectation of a repeat.
Overconfidence Bias (OB)
People who have enjoyed investment success or are experienced at investing are prone to overconfidence. For example, a winning investment will often embolden an OB person to attribute that success to themselves, rather than other possible factors like chance or luck.
As a result, OB people have the tendency to overestimate their abilities. Invincibility is something they erringly assume. OB is a difficult trait to correct because it has elements of both cognitive and emotional disorders.
EXAMPLE: A OB investor has the habit of owning or buying risky investments using their past success as a guideline.
This is just the tip of the iceberg when it comes to investor psychology.