Behavior: Knowing is Half the Battle

We’ve come full circle. We started our series on our Guiding Principles with Patience and end today with a related principle – Behavior. Patience is undeniably a subset of Behavior, but it forms the foundation of good investing and deserves its own spotlight. But behavioral biases in investing go way beyond our lack of patience. Humans are not naturally built for this task. But knowing our shortcomings is half the battle.

Defining biases

“Behavioral biases” is the collective term for the predispositions in our brains that guide decision making. Many conflict with investing best practices. We must know and understand them so that we can avoid their pitfalls.

Their origin story

Some biases have their roots in millions of years of human evolution, while others can be traced to the lived experiences of our parents and grandparents. While it may have served our ancestors well to flee at the first hint of danger, that same instinct does not serve today’s investors well.

Manifestations in investing

Behavioral biases can touch your finances in numerous ways that can damage long-term returns…

…Trading excessively… Holding on to losers too long… Market timing… Chasing shiny objects… Contributing to bubbles and crashes… Overestimating your abilities… Holding too much home bias… Hearing only what you want to hear… Fixating on past prices… Focusing on the near term

Our colleague, Greg Mattacola, wrote a comprehensive piece on the subject of behavioral biases a few weeks ago (Hidden Forces). As an evidence-based investor, and general research nerd, I’ll focus here on a couple interesting studies to bring these biases to life.

The world is ending, what are you doing about it?

Whether it is a pandemic, consequential election or market correction, investment managers are often asked, “What are you doing about it?” In most situations, the correct answer is “Nothing,” or more accurately, “Nothing different.” Our process was built for these moments. But humans have an ingrained “action bias.” We don’t like to sit still as things crumble around us. This bias undoubtedly served us well throughout history. If our ancestors stood still in the face of a charging mastodon, we may not be here today.

For soccer fans, there’s an entertaining study underlying this tendency¹. They looked at professional goalkeepers and their tendency to dive one way or another during penalty kicks. The evidence shows most kicks go down the middle, so logic would dictate elite goalies would do just that. But they don’t. Why? Action bias. With the eyes of thousands of fans on you, a goalie feels much better taking action and missing, then standing their ground a risk looking foolish if the ball hits side netting. So, emotion trumps logic.

For investors this manifests in potentially damaging market timing and excessive trading as nervous investors try to do something… anything… rather than hold their nerve and wait for real opportunities to surface.

Emotional creatures

Another fascinating study² compared investing behaviors of people with healthy brains to those who have brain damage that suppresses their ability to feel emotion. The experiment was simple.

• You have $20
• A coin is flipped 20 times
• Each time you have $1 to bet or you can choose not to bet
• If you win you get $2.50, otherwise you lose $1.25

The logical investor would invest every time, since the positive payoff is much better than the potential loss. Those who could not feel emotion invested 84% of the time, while the others invested only 58% of the time. The more times these healthy participants lost, the less likely they were to invest in the next round.

I’ve seen this exact behavior in the real world. In 2010 I spoke to a young professional about the advantages of investing early in risky assets like equities. They stated they had lost some money in the Financial Crisis and did not trust the equity markets. The S&P 500 went on to rally over 600% since. Ouch.

These behavioral bias examples are just the tip of the iceberg. There are dozens, and the implications are significant. Vanguard estimates that success behavioral coaching can add 1-2% in net return³. Being aware of the biases is half the battle, and this is why we include Behavior as our final Guiding Principle.

1. Bar-Eli, Keidar-Levin and Shein, “Action Bias Among Elite Soccer Goalkeepers: The Case of Penalty Kicks,” Journal of Psychology Volume 28, Issue 5: 606-621 (October 2007)

2. Shiv et al, “Investment Behavior and the Negative Side of Emotion”, Psychological Science, 16(6):435-9 (July 2005)

3. Kinniry et al, “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha^®