To invest better than most other people, we need to have an edge. There are three types of edges for investors:
- Informational Edge: This comes from having better quality or quantity of information about companies, the economy, etc. At Regatta, we have great tools that put high-quality information at our fingertips, but most information is widely distributed in this digital age, so we need another edge.
- Analytical Edge: This is the ability to better synthesize the mountains of information and distill it down to a credible investment viewpoint. Thanks to our MBAs, CFAs, CAIAs, and our decades of experience as professional investors, this is a strong edge for us.
- Behavioral Edge: Even when armed with high-quality information and sound analysis, humans have been proven to make poor decisions due to well-researched psychological biases. At Regatta, we strive to counteract these biases by recognizing them in ourselves, each other, and our clients by constantly reviewing them.
Let’s review some of the most critical behavioral biases from the growing study of behavioral finance.
Anchoring Bias: If we see a shirt for sale for $500, then we see another shirt priced at $100, it will strike us as rather cheap. But if we only saw the $100 shirt, we might not consider it to be cheap. People are wired to evaluate information based on recently observed information. This same bias also means that people are slow to make large changes to their predictions about the future, even in the face of dramatically different information.
Herding Mentality: The herd mentality has helped humans survive this long by helping us cooperate and mimic one another’s behavior to avoid threats and find resources. However, this mentality works against us as investors. The herd mentality leads certain investments to become very popular which drives them to become overpriced. Overpriced investments always fall back to earth without warning at some point, devastating the lemming investors.
Recency Bias: We are naturally programmed to make predictions about the future that looks an awful lot like the recent past. When markets have been rising, our brains tell us that this is a good time to invest, and when they have been falling, we think that the markets will keep going lower. To help counteract this, we study the long-term history of economies and investments, looking at centuries instead of just the last few years.
Overconfidence Bias: The survival of our species has required that people wake up every morning feeling that they can take on life’s challenges. People are therefore preprogrammed to have an irrationally high dose of self-confidence. This is all fine and good…if we are not making investment decisions. Imagine asking 100 people a random quantitative question (like how many miles is Shanghai away from Anchorage) and telling them to answer with a range (high and low) such that the correct answer is 50% likely to be inside that range. If people were purely rational, about 50 out of the 100 people would answer with a range that contains the correct answer. Only 10-15 people actually will do so! We all need to be aware that our predictions and projections are far worse than we naturally think. That’s why we diversify!
Confirmation Bias: In this age of social media and web search algorithms, an understanding of confirmation bias is more important than ever. Confirmation bias is our tendency to seek out information that agrees with our hypothesis, rather than information that disproves it. This tendency leads us to deepen our conviction in our original thought, even though there may be an ocean of disproving evidence out there that we simply have not looked for. One trick I use is to intentionally focus on reading research and articles that appear to conflict with my worldview.
By studying our biases and taking specific steps to mitigate them, we can make much better financial planning decisions and achieve better investment outcomes.