Level 5 Financial Blog
Our next personal finance bias is a behavior that is very subtle and insidious. Familiarity bias causes investors to underestimate the risks associated with investing in the securities of an organization that is well known to them. This is very prevalent with employer stock in 401k retirement plans.
Herd instinct is the observed human behavior which causes us to join groups and follow the actions of others. Also known as bandwagon effect, it can explain why people take various actions. It has even been observed in small children who will often want to do “what everyone else is doing.” For investors, herd bias can move markets strongly to the upside, but unfortunately, also to the downside.
Many of the investing and behavioral biases we’ve been discussing are most readily understood when contrasted against classical economic thinking. Such is the case with “mental accounting”. Classical economic theory holds that money is fungible, that is, every dollar is identical to every other dollar. However, observed behavior in real life shows that many people don’t act as if this were true. Richard Thaler, a Nobel prize winner in Economics coined the term “mental accounting” to describe such behavior and its associated impact on our financial decision-making.
Escalation of commitment is a behavior that can sometimes make a bad situation even worse. This pattern of behavior involves the prospect of facing increasingly negative outcomes from a past investment decision. A rational investor would re-evaluate their original decision process and incorporate new information. This new information may possibly lead to the conclusion that the original investment was a mistake, and the rational action would be to liquidate, in order to eliminate possible future losses. However, for many people, there’s a reluctance to admit the past error of judgment and they escalate their commitment by investing even more money into the same declining security.
The behavioral biases we’ve been covering in recent posts certainly affect our decision making processes in financial affairs. There’s also impact in other areas of our lives, and this is especially the case with today’s topic. Psychologists have named this bias self enhancement, but most of us would readily refer to it as overconfidence. Self enhancement is the tendency to attribute positive qualities to one’s self and to take credit for one’s successes, whether or not these are accurate beliefs. Overconfident investors will attribute past success to their own skill and reject the role of fortuitous timing or other factors in those outcomes. Conversely, these same people will blame their failures on factors outside of their control.