Beatles Breakdown: Your Behavioral Biases Toward Investing – Part 2

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Think you can beat the markets? Research shows that you have a bigger hurdle to face: First, you have to beat your own sneaky brain. With a little help from your friends at the Wherewithal blog, you can understand the biases that trip up even the most coolly logical of investors.

In Part One, we covered some of the behavioral biases beginners can make, often without realizing it.

Part Two tackles the “sophomore slip-ups” you find among investors who have been at it a while. A little bit of knowledge, as they say, can be dangerous. These are:

1. Loss aversion
2. Endowment effect
3. Disposition effect
4. Mental accounting
5. Herd behavior
6. Representative bias

Just for fun, we found well-known Beatles tunes that seem to have explained it all in advance.

1. Loss aversion

“Got a good reason, for taking the easy way out” (Day Tripper): When it comes to money, we want to win, win, win and never lose. The bias is so strong that we fear losses much more than we enjoy gains, even if the results are exactly the same. This is “loss aversion,” part of a larger notion known as prospect theory.

Simply put, given a choice of settling or going double-or-nothing, we will gladly settle. Yet investing is not like flipping coins. Some stocks should be held longer for the additional gain; likewise, some stocks should be sold sooner to avoid a greater loss.

2. Endowment effect

“Nothing’s gonna change my world” (All Across the Universe): A truism: We value things we already have. Asked to sell a possession, we place a high price on it, much higher than we would offer to buy it in the first place. In investment terms, the “endowment effect” means we believe in the inherent value of our current holdings, even if logic dictates we should sell them.

3. Disposition effect

“When I get to the bottom I go back to the top of the slide, where I stop and I turn and then I go for a ride” (Helter Skelter): There’s a practiced investment strategy known as momentum investing. Put simply, it means holding on to winners and cutting losses quickly on losers. That can sound like falling for the law of small numbers, but momentum investors are simply playing with the pride of ordinary investors, who do the opposite: They sell winners too fast and hold on to losers far too long. This is the “disposition effect.”

People like winning stocks, so they avoid selling, even though they should periodically sell winners and redistribute money to the losers, a strategy known as rebalancing. Similarly, because of loss aversion, people hate losing, so much so that they will keep a stinker of stock until the company literally goes bankrupt.

4. Mental accounting

“I’ll buy you a diamond ring my friend if it makes you feel alright, I’ll get you anything my friend if it makes you feel alright” (Can’t Buy Me Love): In a perfect world, you could easily rebalance your investments, selling winners and buying more of the losers in a methodical way. Thoughtfully done, this strategy smooths returns over time and helps growth your wealth. In practice, however, we fall victim to the bias of “mental accounting,” first described by Richard Thaler.

That is, we easily compartmentalize individual investments and act as if they are unrelated. Over time, as their values change, we continue to keep them separate in our minds, much as we keep a savings account for a vacation separate from money we use to pay a power bill or tuition. Or buying a diamond ring (many years of power bills!) to make someone happy.

5. Herd behavior

“What can I do, what can I be, when I’m with you I want to stay there” (Got to Get You Into My Life): If you follow the herd, as the saying goes, the view never changes. When it comes to money and investing, however, that’s exactly the view we prefer. There’s a strange tendency to believe that there is safety in numbers, that is, if the market is rising fast, we should stay in and ride it up rather than be the lone fool who sells and runs to cash.

Of course, it is exactly this mentality that feeds market bubbles and the crashes that inevitably follow. Because the stock market operates on signals among people (despite so much electronic trading), actions taken by a few can create “information cascades” that in turn trigger large movements in stock prices, even in the absence of actually new information. Researchers call this “herd behavior.”

6. Representativeness bias

“You’re asking me will my love grow, I don’t know, I don’t know, stick around, and it may show” (Something): Your brain concludes that two investments that seem to be similar are in fact exactly the same, and thus represent the same risk and reward.

For instance, you loved how your Starbucks stock rose and rose. It seems like Panera Bread has the same model. Yet each company has its own management, its own history, and perhaps quite different customers. This is called “representativeness” bias.

Investors apply representativeness bias to all kinds of indicators that can seem foolproof, such as earnings growth and increases in the share price (numbers are so comfortingly uniform!). People start to chase winners and, for a while, it works. Then it doesn’t anymore and the stock drops.

Stay tuned to the Wherewithal blog for Part Three, where we’ll present the behavioral biases that even the longtime investing pros stumble over.

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