The New Year typically brings a zest to starting off right. We reflect on the previous year and determine how and what we could have done better. This not only applies professionally, but personally as well. At Maclendon we strive to be great “BGR8®”. But, a part of being great is also being cognizant of our weaknesses. Since this is a New Year, we thought it would be helpful to explain some common cognitive biases investors have as they review their allocations and investment decisions for the coming year. Cognitive biases impair your decision making and can hinder you from achieving your long term goals. Although there are many biases to list, here are some of the more common biases that investors fall victim to.

Confirmation Bias

Confirmation bias is a tendency for investors to lean toward information that confirms their hypothesis whether it is true or not. This psychological phenomenon causes investors to overlook information that might contradict their preconceptions. Being aware of this bias helps investors as it might force them to look for opposing views and play devil’s advocate when evaluating an investment. An example of confirmation bias would be when an investor gets emotionally attached to a position despite the underperformance. Instead of selling and cutting their losses they hold and or add to the weakness. They subsequently only seem to consider information that builds on their thesis and miss the forest amongst the trees. This can compound losses and derail a financial plan.

Herding Effect

As the name implies, investors tend to follow the herd. This bias is characterized by acting and making decisions in the same way as other investors around them. This natural desire to be part of the ‘in crowd’ can impair your ability to make good decisions. We see this every day in investing. Once an idea becomes “hot,” investors pile in hoping to get a piece of the action. Historically, there has been times where this has not worked out for investors, particularly in the internet stock boom of the late 90’s and subsequent tech bubble crash in the early 2000s. In more recent years we have seen the same herd mentality in marijuana stocks, 3D printing, and even the call for higher interest rates. This year the herd followed the selloff in oil and bought into biotech.

Sometimes by not following the herd and taking a contrarian stance has reaped huge rewards. For example, during the financial crisis when everyone was bullish on the housing market, a few investors broke away from the herd and shorted the market. This turned out to be one of the best calls of all time.

Anchoring

Anchoring is the mental proclivity to “anchor” our thoughts to a reference point to determine some tentative solution to a problem. This reference point could have no applicable or logical significance, yet we still tend to use it in our decision making. If used in investing, anchoring could lead to status quo bias. Status quo refers to keeping the way things are. Basically it is avoiding action or change. But, as you will see, this can be detrimental to your portfolio. For example, we have seen a tremendous run in the markets and could “anchor” ourselves to the idea that the stock market always goes up. Therefore, investors do not rebalance and readjust their portfolios, or maintain the “status quo.” This type of bias could leave investors either taking on too much risk or not enough.

Overconfidence Effect

Overconfidence is sometimes referred to as the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim.¹ Overconfidence can also be a byproduct of confirmation bias as we lean to reasons that support our thesis and explain why an outcome may have or have not occurred.

An example of overconfidence is when investors rely on previous successes to predict future outcomes while underestimating the margins of error. If they were able to place a profitable trade they can become overconfident that they can repeat the process. When an investor is overconfident they tend to overestimate their knowledge and underestimate risks. In a sense it is a form of invincibility. This is said to contribute to bubbles and subsequent market crashes.

As with all of these devious biases, they can lead investors to make poor decisions. We have only named a few and have barely scratched the surface. These biases can make even the smartest and most sophisticated investors make bad decisions. Understanding and being aware of these shortcomings can help you avoid these mistakes and potentially help you achieve your financial goals. As humans we are not perfect and we must remove the emotional aspect out of investing and remain objective. Being aware and knowing how to counter such biases is the first step and should be on the top of your mind to avoid such irrational investor behavior. So, looking forward to the New Year, it’s time to shake these biases and start off on the right foot.

At Maclendon we have the flexibility and ability to customize portfolios to offer these investments to our members. We see social investing as an area of opportunity in wealth management that the industry should prepare for as investors look to invest in projects they are passionate about.