6 minute read
There’s a fundamental dilemma in markets and investing that many in the mainstream seem to forget – or maybe simply never learned.
And this is the fact that markets – at their core – are social systems.
What do I mean by social systems?
In short, it’s a series of interrelationships existing between individuals, groups, corporations, institutions, and financial markets that form a coherent social structure.
And what do these have in common? They all begin with people.
Because of this, it’s important to understand how people influence these social systems – and no place shows this as well as in markets.
Think of prices as the collective information of all inputs – from fear and greed to processing information and irrationality.
Are people feeling risky and greedy? Prices will rise.
Are people feeling risk-averse and fearful? Prices will sink.
Thus it’s clear that emotions and biases are critical drivers in market prices.
It’s literally in our DNA to do so - hence the repeated cycles of boom and bust; fear and greed.
Simply put, these persistent flaws and biases influence our decision-making, often resulting in irrational choices.
· Compounding the issue, scientific findings1 indicate that there are over 150 of these factors affecting us daily.
But not all hope is lost. . .
By taking the time to recognize and identify these biases, we can take the initial step in mitigating their impact on our financial decisions and potentially enhancing economic outcomes.
With that said, let’s take a closer look at the four emotional biases and cognitive flaws I believe you should look out for.
Here are Four Emotional Biases and Cognitive Flaws That Impact Investors
The Endowment Effect: Overvaluing What You Own
The endowment effect reflects the tendency for individuals to overvalue items they own, and scoff at prices for items they do not own.
Because of this bias, sellers may ask for higher prices, seeking more than the item's true market value.
For example, an individual wouldn’t pay $2 for a new mug, but wouldn’t sell his own for less than $5.
Thus - in simpler terms - the endowment effect arises when there's a disparity between what a buyer is willing to pay and what a seller is willing to accept. This gap often occurs because buyers reference the lowest available price, while sellers focus on the highest prices when determining a fair value.
Now, I am sure you can see how this affects markets.
Sellers always want a higher price for their investments, and although buyers may be skeptical of paying, they will sometimes overpay for fear of missing out.
Then once they buy stock XYZ, they’ll only part with it at a higher price. And on and on.
This bias can help push prices both higher and lower than what fundamentals justify.
2. Information Asymmetry: The Risks of Unequal Knowledge
This isn’t exactly a bias, but an inherent issue in any transaction between individuals or groups.
In short, asymmetric information means unequal or lopsided information - especially in business or financial dealings - where one party has more detailed information than the other.
· For example, imagine the sale of a used car where the seller typically knows more about the vehicle than is disclosed to the buyer.
Or in the stock market – the seller may know something about stock XYZ that the buyer doesn’t. And vice versa.
· Another example, remember the subprime housing chaos in 2008? The big banks knew that many of the loans they were underwriting were suspect. Hence why they packaged many of them up and sold them to Wall Street through mortgage-backed securities (MBS) to get them off their books.
The poor buyers – on the other hand - had no idea what was really in those MBS.
Asymmetric information exists virtually everywhere, making win-win business agreements and transactions almost impossible to come by.
That shouldn’t come as a surprise though, right? You live in the real world. I’m sure you’ve seen this firsthand.
Well, the problem arises in economics and finance because models and theories use the assumption that all buyers and sellers have complete and instantaneous knowledge of all market prices and their utility.
Thus, if the model makes these unrealistic assumptions, then the entire model is potentially flawed.
So, buyer and seller beware. . .
3. Recency Bias: Why the “Hot Hand” Can Mislead Investors
Recency bias involves overemphasizing recent experiences or the latest information when estimating future events. This tendency misleads us into believing that recent events can accurately predict how the future will unfold.
Meaning when things have been good recently, we expect them to continue. And vice versa.
This also ties into the famous “hot hand” fallacy. . .
In essence, the hot hand fallacy is the inclination to think that someone successful in a task is more likely to succeed again. This stems from the notion that athletes with a "hot hand" will keep achieving success.
For example, imagine observing a stock portfolio where five consecutive investments yield positive returns. The assumption might be that the investor is on a "hot streak" and will continue succeeding. This belief relies on a small sequence of random events, overlooking the chance nature of the initial gains.
Thus, the hot hand fallacy in stock markets can lead to the misconception that a short-term pattern predicts future success, neglecting a more accurate assessment.
Making matters worse, this can create false confidence in the continued streak, so individuals pile into the trade expecting further success.
That is, until it doesn’t. And things quickly unwind.
4. Present Bias: Choosing Short-Term Gains Over Long-Term Success
The present bias – which is known as hyperbolic time discounting - is our tendency to favor immediate rewards over larger, delayed rewards in the future.
Such bias affects people at many levels - from eating and addiction to finances and risk-taking - where the immediate pleasure outweighs long-term concerns.
In short, people tend to discount how they’ll feel in the future.
For example, consider having extra funds available. A prudent choice would be to invest for retirement. However, the allure of immediate gratification by buying a new video game or car today feels better.
The individual knows what the logical choice is, but that little voice in their head says, “Don’t worry, we can always save for retirement next time.”
But then next time comes, and the cycle repeats itself. . .
Another example is how investors often grapple with the decision between pursuing high short-term yields (which come with more risk) and opting for long-term investments that typically offer lower risk and returns.
The high-flying stock offers immediate gratification, but it can also be destructive if those risks reveal themselves.
So next time you feel the urge to discount your future self, think about hyperbolic time discounting (a mouthful of a word).
Final Thoughts: Recognize Biases for Better Financial Outcomes
The dynamics of markets are deeply rooted in the social systems driven by human behaviors, emotions, and biases.
This reality underscores the importance of recognizing and understanding the impact of biases on financial decisions.
And by acknowledging these biases, we can take proactive steps to mitigate their impact, and hopefully foster better financial outcomes and navigate the complexities of markets with a more informed perspective.
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Disclosure:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax, or investment advice or an investment recommendation, or as a substitute for legal counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy, or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance.
Information contained in the materials included is believed to be from reliable sources, but no representations or guarantees are made as to the accuracy or completeness of information. This document is provided for information purposes only and should not be considered as investment advice
Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA / SIPC. Advisory services and securities offered through Dunham & Associates Investment Counsel, Inc.