Basic Concepts of Behavioral Investing

Whether you’re an individual managing your own investments or a professional fiduciary responsible for managing assets in a trust, behavioral investing habits are a serious threat to your investment management strategy.

Human psychology tends toward habits and impulses that can steer you toward poor investment decisions. The risks of these behavioral tendencies are heightened when you aren’t aware of these inclinations—or, even worse, when you deny their existence.

Just as individuals and fiduciaries must account for various financial and economic factors when managing investments, they must also account for their behavioral investing tendencies to deliver the best results for themselves or the estate they serve.

Behavioral investing mechanisms

The various manifestations of behavioral finance can be grouped into a few different categories. 

One type of behavioral impulse refers to forms of cognitive bias, which we describe in more detail below. Another example is mental accounting that sets investing goals or price-points based on personal desires rather than best practices for investment management.

Investors and investment managers can also be led astray by a behavioral investing tendency known as loss aversion, meaning their investment management is motivated by a fear of loss rather than total returns.

The Importance of Being Aware of Cognitive Bias

Cognitive bias is an unavoidable factor in how our minds work. Our various biases can affect almost any decision we make in our daily lives—but they can be particularly damaging when we let them dictate our investment and financial planning decisions.

With more than 100 different cognitive biases that can compromise your decision-making, it is impossible to be aware of every influence that can impact each decision you make. But you can improve your awareness of common cognitive biases by educating yourself on what they are and how they develop.

Common cognitive biases include:

• Confirmation bias: This bias occurs when you look for data and trends that validate what you want to be true. This also causes you to ignore data that doesn’t agree with your hypothesis.
• Anchoring bias: This is what happens when you overvalue the first information you receive when conducting research, rather than valuing all information equally.
• Narrative bias: This type of bias is the assumption that data points belong to part of a larger narrative, regardless of whether that is true or not. A common example of narrative bias occurs when investors favor a particular stock because of the stock’s comeback story—even if the data doesn’t necessarily suggest a comeback is imminent.
  

Minding the Emotional Gap in Your Investment Strategy

Although behaviorally motivated investment decisions can take different forms, many of those decisions are caused or exacerbated by a phenomenon known as the “emotional gap.” 

The emotional gap refers to any investment decision that is influenced by emotions rather than qualitative data and investment analysis. Emotional responses to economic or political events—particularly those that drive knee-jerk reactions—are a prime example of the emotional gap’s potential impact on your investment strategy.

These emotional responses could lead to overreactions in your investment strategy based on natural disasters, economic reports, presidential elections, and other major events. 

The emotional gap can also be the primary driver for investment management decisions based on a fear of suffering losses, concerns about your financial stability, or other personal variables.

Avoiding Liability by Removing Bias

Biases don’t just create a conflict of interest between your investment strategy and your emotions. Fiduciaries who base their management practices on these biases could be held liable if it can be shown the fiduciary’s personal bias impacted what was in the beneficiary’s best interest. 

None of us can completely remove bias, but fiduciaries should carefully review the trust document and interview the beneficiaries when appropriate. In some cases, the trust might stipulate investments or actions that go against an individual’s personal preferences (e.g., required investments in oil that go against a person’s preference in green investments). 

If the fiduciary takes the case, it behooves them to follow the trust, as the trust is the overriding authority. In the above example, a fiduciary’s bias toward green investments could become a liability because it would run contrary to the trust.  . The Uniform Prudent Investor Act (UPIA) provides guidelines for steering clear of trouble, as it creates a framework of investing best practices that can override any inherent biases.

As you work to identify and defend yourself against biases and behavioral investing tendencies that may compromise your decisions, one of the best safeguards you can implement is a relationship with a trusted investment management company. As experts in UPIA investment management, Prudent Investors offers the expertise and data-driven strategies every investor needs to make sound investing decisions that aren’t motivated by behavioral tendencies.

Schedule an introductory meeting today to learn more about our investment methods and our empirical approach to supporting our clients.