As a financial advisor, I am biased. Not because of my profession, mind you, but because of my humanity. All of us are subject to a potpourri of survival-instinct biases that happen deep in our brain stems. It’s why a sudden, but harmless noise still makes us flinch. It’s also why investors often behave irrationally. Since financial advisors are human too, we need to be on the look-out for these same biases. Here are a few examples of what I mean.
We humans love to say, “Yup, I thought so,” which is why confirmation bias causes us to focus on information that supports our beliefs, and to tune out conflicting data. This can cause some financial advisors to make recommendations that happen to compensate them more handsomely or that they’re being pressured to sell, to keep their job, as I covered here.
Once we get used to something, we tend to prefer it over the new and different. That may be why some advisors continue recommending an inferior investment strategy even once they’ve been made aware of better solutions. If your only tool is a hammer, sooner or later you figure out how to make every project look like it needs a nail.
Confidence helps us when life gets us down. But overconfidence is dangerous. It tempts advisors to play fancy, high-cost tricks such as investing clients in complicated hedge funds and similar alternative strategies, believing they can be one of the lucky few who manage to “beat the market.”
Recency fools us into paying more attention to hot trends instead of more durable evidence. When advisors get drunk on recency (especially if it’s mixed with a shot of overconfidence), they try to cherry-pick high-flying winners, mistakenly assuming immediate past performance predicts future success. Or, conversely, a run of bad news causes them to yank their clients’ money out of the market, just in case there’s some imminent crash on the way.
The good news is, once we’re aware of our biases, they become a little easier to manage. It’s like having a detailed description of an escaped convict. At least you know what to look for.
But awareness alone isn’t enough. We know our minds are going to play tricks on us. We know our biases may steal our best judgment. So one of our best defences against advisor and investor biases alike is to adhere to the tenets of evidence-based investing. There’s decades of evidence stacked against the odds of beating the market through instinct-driven market timing and stock-picking, and decades of the same supporting a more steadfast, globally diversified approach for capturing the market’s expected returns.
When our vision is clouded by bias, this evidence may be “out of sight out of mind,” as the saying goes, but that doesn’t mean it isn’t there!
What is evidence-based investing? Take a look at this Q&A for a handy infographic that showcases its key features.