by FPA member David Zuckerman, CFP®, CIMA®
Last Updated: August 20, 2012
Although perseverance is typically seen as a positive attribute, it can actually work against you when it takes the form of a behavioral bias that leads to irrational decisions. By combining the study of psychology with economics, behavioral finance offers valuable insight into belief perseverance biases.
According to traditional economics, people act rationally by objectively evaluating all available information. Unfortunately, rational decision making is often encumbered by behavioral biases that favor existing beliefs and opinions over new information; and these biases can lead to irrational decisions and suboptimal outcomes. By familiarizing yourself with different belief perseverance biases, you can become a better investor.
The human mind has a tendency to favor existing opinions, even when new information runs contrary to prior beliefs; and by failing to objectively evaluate new information, people often allow old, irrational beliefs to persevere.
As an example, many investors fell victim to conservatism bias during the financial crisis of 2008-09 and did not benefit from the robust recovery in the stock market that followed the financial crisis. These investors stuck to bearish portfolio holdings despite signs of economic recovery and improving corporate profits. The result for many of these “perma-bears” was that the financial crisis took a far higher toll on their wealth than it would have had they objectively evaluated new information.
Of course, the quantity and complexity of information available to investors can be overwhelming; and sifting through large amounts of data and reformulating an opinion can be mentally taxing and stressful. So what can you do the next time you sense a tendency to allow irrational beliefs to persevere? Try keeping an investment journal which contains information that is contrary to your existing opinions. Perform a new round of fundamental analysis when the data indicates that your opinion may be wrong.
Illusion of Control Bias
Illusion of control bias refers to the mind’s tendency to believe that outcomes can be controlled in situations where no control is possible. As an example, a study of hypothetical lottery participants showed that people who were allowed to pick their own lottery numbers were willing to pay higher prices for each ticket than people who were required to use randomly generated lottery numbers.
One of the most common manifestations of this illusion of control bias occurs when an investor trades too frequently, because of the illusory belief that trading more provides greater control over outcomes. In fact, research has shown that frequent trading hurts returns and investors who trade online are particularly susceptible to this behavioral bias.¹
Another example of illusion of control bias would be an investor that decides against diversification in favor of concentrated exposure to shares of his own company’s stock. The reality is that most people have virtually no control of the company they work for; and by holding too much exposure to company stock, they are putting both their job and their portfolio at risk if the company underperforms. Under no circumstances should your employer’s stock comprise more than 10 percent of your investment portfolio, and many professional money managers recommend limiting exposure to 5 percent or less of your total portfolio.
Keeping an investment journal can also be helpful in combating the illusion of control bias. By recording your reasons for making investment decisions, you can benefit from hindsight and evaluate your reasoning. Then, if you spot a pattern of suboptimal outcomes that is associated with a particular type of reasoning, consider reformulating your analysis in a manner that excludes the suspect factor. For example, many investors find themselves selling stocks when bad macroeconomic news hits the headlines in the hope that they will be able to avoid future losses. The reality, however, is that few investors are able to time the market with repeatable accuracy. So if your attempts to avoid future losses are not successful, consider a different investment strategy that focuses on fundamentals as opposed to timing.
If you need help counteracting belief perseverance biases or assessing your susceptibility, consider consulting a CERTIFIED FINANCIAL PLANNERTM from the Financial Planning Association® with the experience and expertise necessary to guide you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.
¹Michael Pompian, Behavioral Finance and Investor Types (John Wiley & Sons, Inc., 2012), 25-30