Level 5 Financial Blog
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.
Our next behavioral bias can lead us to make decisions that are less than optimal, often resulting in missed opportunities both in investing and in other facets of our lives. Endowment effect causes us to place a higher value on something that we already own, even though there might be ample evidence that an identical object could be readily acquired elsewhere for a lower price. A well-known study starts with a college professor who gives a coffee mug to each student in one of his class sections but does not give such gifts to his students in a second class section. A week passes and the professor asks all of the students to place a value on the mug. The students in the first class consistently value the mug at a higher price than the students from the second class. This overvaluation persists even when all the students are provided with the current selling price of the mugs at the university book store.