In my book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” there’s a detailed discussion on how investors can choose the right asset allocation for them, with the focus being on determining one’s ability (capacity), willingness (tolerance) and need (the rate of return required to achieve a goal) to take risk.
To help with issues surrounding the willingness to take risk, risk tolerance questionnaires have become a very popular. Unfortunately, as Joachim Klement showed in his article, “Investor Risk Profiling: An Overview,” published in the June 2018 CFA Institute Research Foundation brief “Risk Profiling and Tolerance: Insights for the Private Wealth Manager,” the “current standard process of risk profiling through questionnaires is found to be highly unreliable and typically explains less than 15% of the variation in risky assets between investors. The cause is primarily the design of the questionnaires, which focus on socioeconomic variables and hypothetical scenarios to elicit the investor’s behavior.”
He went on to explain that there are three problems questionnaires typically fail to address: Our genetic predisposition affects our willingness to take on financial risks, the people we interact with shape our views, and the circumstances we experience in our lifetimes—in particular, during the period psychologists call the formative years—influence our outlook.
Being aware of biases at least gives us a chance of addressing them, either on our own or with the help of a financial advisor. Michael Pompian provides guidance on behavioral biases in his article, “Risk Profiling Through a Behavioral Finance Lens,” for the aforementioned CFA Institute Research Foundation brief. (Pompian also is the author of the 2012 book “Behavioral Finance and Wealth Management,” which I recommend for both investors and advisors.)
In his article, Pompian places biases into two broad categories: cognitive and emotional. Cognitive biases have to do with how people think and result from memory errors or faulty reasoning.
He writes: “There are two types of cognitive biases: belief perseverance and information-processing biases. Belief perseverance biases concern people who have a hard time modifying their beliefs even when faced with information to the contrary. It is a very human reaction to feel mentally uncomfortable when new information contradicts information you hold to be true.”
Emotional biases are the result of reasoning that is influenced by feelings, especially during times of stress.
Pompian then analyzes four different investor types—conservative, moderate, growth and aggressive—and reviews the biases likely to be present with each type.
Their risk tolerance is low and they tend to make emotional errors. Being worriers, they tend to place great emphasis on financial security and preserving wealth, and to obsess over short-term performance. They also are slow to make investment decisions because they are uncomfortable with change and uncertainty. Their behavioral-bias orientation is emotional:
- Loss aversion: Feeling the pain of losses (especially realized losses) more than the pleasure of gains, they tend to hold onto losing investments too long.
- Status quo: They feel safe keeping things the same, even if they are not working optimally.
- Endowment: They assign greater value to an asset they already own than to a prospective purchase.
- Anchoring: They tend to cling to investments, anchoring on a specific price (such as the purchase price, or a historic high).
- Mental accounting: Treating different pockets of assets differently, they tend to use a “bucket” approach instead of evaluating the portfolio as a whole.
Their risk tolerance is moderate and they tend to make cognitive errors. They often do not have their own firm ideas about investing, instead following the lead of their friends and colleagues. They tend to be comfortable with the latest, most popular investments, often without regard to a long-term plan. In addition, they often overestimate their risk tolerance. Their behavioral-bias orientation tends to result in cognitive biases such as:
- Recency: The predisposition to recall and overweight recent events and/or observations and to extrapolate patterns where none may actually exist.
- Hindsight: Belief that investment outcomes were predictable.
- Framing: The tendency to respond to situations differently depending on the context in which a choice is presented (framed). For example, when questions are worded in a “gain frame” (e.g., an investor is asked to suppose an investment goes up), a risk-taking response is more likely. When questions are worded in a “loss frame” (e.g., an investor is asked to suppose an investment goes down), risk-averse behavior is the more likely response.
- Cognitive dissonance: When a person believes something is true only to find out that it is not, he or she tries to alleviate discomfort by ignoring the truth and/or rationalizing decisions (often ending up throwing good money after bad).
Moderate investors also tend to make the emotional error of regret-aversion bias, which is the fear of taking decisive action because they worry that, in hindsight, whatever course they select will prove unwise. Regret aversion can cause moderate investors to be too timid in their investment choices because of losses they have suffered in the past.
Their risk tolerance is moderate to high and they tend to make cognitive errors. Growth investors tend to be active investors who are often strong-willed and independent thinkers. They also tend to be self-assured and “trust their gut” when making decisions. However, when they do their own research, they may not be thorough enough with due diligence tasks. They also can be subject to maintaining their views even when those views are not supportable. Some growth investors may appear obsessed with trying to beat the market and may hold concentrated portfolios. Their behavioral-bias orientation tends to be cognitive and reflect biases such as:
- Conservatism: The tendency to cling to a prior view or forecast at the expense of acknowledging new information.
- Availability: Estimating the probability of an outcome based on how prevalent that outcome appears to be in one’s own life.
- Representativeness: Representativeness bias occurs due to a flawed perceptual framework when processing new information. To make new information easier to process, some investors project outcomes that resonate with their own pre-existing ideas.
- Self-attribution: The tendency of people to ascribe their successes to their talents and to blame failures on outside influences.
- Confirmation: The proclivity actively to seek information that confirms one’s claims while ignoring or devaluing evidence that discounts them.
Their tolerance for risk is high and they tend to make emotional errors. They often are the first generation in their family to create wealth. They are even more strong-willed and (over)confident than growth investors, which often leads to chasing high-risk investments. They also tend to change their portfolios as market conditions change, which often creates a drag on investment performance. Finally, they are often “hands on” and want to be involved in the investment decision making. Their behavioral-bias orientation is emotional, tending to exhibit the following biases:
- Overconfidence: An overestimation of one’s quality of judgment, often leading to failure to diversify and concentrated positions in risky assets.
- Self-control: The tendency to consume today at the expense of saving for tomorrow.
- Affinity: The tendency to make irrationally uneconomical consumer choices or investment decisions predicated on how one believes a certain product or service will reflect held values.
- Outcome: Focus on the outcome of a process rather than on the process used to attain the outcome, leading to confusing luck with skill.
- Illusion of control: Believing that one can control or at least influence investment outcomes when, in fact, one cannot. That often leads to persistent “tinkering” with investments.
Behavioral biases can cause even the most well-developed and well-thought-out investment plans to fail. One reason, as physicist Richard Feynman noted, is that “the first principle is that you must not fool yourself and you are the easiest person to fool.” The best cure for such biases is to become educated about them so that at least you are aware you can be subject to them. Perhaps you can even learn to overcome them. If you recognize that isn’t the case, or don’t have sufficient knowledge to invest on your own, you can consider hiring a fiduciary advisor who can help you overcome any particular behavioral biases you might gravitate toward.
For those interested in learning more about behavioral biases, I recommend Nobel Prize-winner Daniel Kahneman’s book, “Thinking, Fast and Slow,” and my own book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them.” The latter covers 77 mistakes, both cognitive and behavioral.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.