Part 1

By Andrea Young on August 22, 2023

By Chris Dooley, MBA, CFP®, EA
Senior Wealth Advisor

In case you missed it Dr. Harry Markowitz passed away last month at 95 years old. Markowitz is known as the father of Modern Portfolio Theory and was awarded a Nobel prize in 1990 for his work. Modern Portfolio Theory (MPT) refers to a widely adopted investment theory that allows investors to assemble an asset portfolio that maximizes expected return for a given level of risk. The theory also assumes that all investors make rational decisions with their money. Enter Behavioral Finance; the study of how psychology affects finance.

In the world of investing, emotions run high. This is because money is involved, and money is an emotional subject. Thus, behavioral finance derives from the idea that investors engage in several irrational behavior patterns. Being consciously aware of our own irrational actions in investing is the first step toward becoming a better investor. It allows us to stop and think, practice critical thinking and realize that we might fall into the traps and pitfalls of such thinking fallacies.

Heuristics

When it comes to being aware of our own irrational actions it helps to understand the concept of heuristics. Heuristics is the process by which humans use mental shortcuts to arrive at decisions. These mental shortcuts can be very helpful as they allow people to solve problems and make judgments quickly and efficiently, but they can also cause cognitive bias. One example is the availability heuristic which describes our tendency to use information that comes to mind quickly and easily when making decisions about the future. In the wealth management world, this would be akin to choosing the latest high-flying growth stock and assuming that because it has done well lately that it will continue to do well.

Cognitive Biases

If, like me, you prefer to make rational decisions rather than irrational ones we need to first identify the most common cognitive biases. Let’s look at Anchoring:

 Imagine you’re out shopping for a present for a friend. You find a pair of earrings that you know they’d love, but they cost $100, way more than you budgeted for. After putting the expensive earrings back, you find a necklace for $75—still more than your budget, but hey, it’s cheaper than the earrings!

Another example is the fear of regret. This is the tendency to take no action rather than risk making the wrong one. This often causes an investor to hold onto a stock that’s losing value, because if they sold and it rebounded they would feel even worse. 

In part 2 of the series, we will look at more examples of these biases. We will discuss recency bias, confirmation bias, overconfidence, herding, Prospect Theory, Gamblers Fallacy and more.

Part 3 in the series will share approaches you can use to eliminate and mitigate these biases from clouding your judgment. This piece will also share how professional wealth management professionals use this information to ensure we are being as rational as possible when making decisions.

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