Perception and Reality

Investors, like all humans, are biased toward making decisions based on the information at hand. But too often you get a distorted view of reality and that can lead to bad money behavior. Here’s how to overcome this perceptual problem.

Psychologists Daniel Kahneman and Amos Tversky coined the term availability bias: our tendency to use the information available to us to make quick judgments.

For example, if all of your friends and co-workers own a smartphone, you probably figure that most people have smartphones. In reality, not even half of Americans own one. That’s a problem if you expect to deal with customers using an app on their mobile screens. Or you might have an irrational fear of flying thanks to news reports of a recent plane crash. Statistically, you are safer traveling in a plane than in a car. So you stick to time-consuming ground transportation.

When it comes to investing, availability bias can cause bad decisions. My grandmother, for instance, grew up during the Great Depression. She was an extremely frugal person. She saved everything. She even washed and reused zippered sandwich bags.

She also never invested or saved one cent in the market. As a child she saw what the market did to her friends and family – and she wanted no part of it. There were many other factors that led to the Depression, but according to the information she had readily available to her, it was the market’s fault. That meant that she had very few assets to give her a comfortable living in her old age.

Fast forward roughly 80 years and people have very similar feelings in the aftermath of the Great Recession. People who lost half of their net worth in 2008 or sold their portfolio at the bottom in 2009 feel a lot like my grandmother, apprehensive about investing. A newly graduated college student who just landed a great job in a growing field and watched his wealth grow in the company 401(k) while the Dow Jones Industrial Average breached 14,000 points probably doesn’t feel the same way.

Much of our availability bias stems from what we read, what we hear and who we associate with. It’s extremely difficult to go against the grain. This is why co-workers invest in the same funds in their company retirement plan, yet have completely different ages and goals.

Another example where availability bias wreaks havoc on our portfolios is our tendency to chase returns. This is when an investor buys a stock or fund based on how well it performed in the past. Looking at the information available, he reasons that it’s a good bet. We are much less likely to buy a fund with negative returns in recent years.

But there is a reason brokers are careful to say that past performance doesn’t equate to future growth. Today’s winner might be tomorrow’s loser. Chasing returns is a very efficient way to continually buy high and sell low. Take Bank of America (BAC). In 2011, it was the worst performer in the Dow. Last year, it gained 45%, making it the best performer in the index.

How can investors avoid falling into the availability bias trap?

Educate yourself. Do your due diligence and learn more about your investments, your proposed investments and why you’re making the decision you’re about to make.

Know your time horizon. A lot of your investment decisions come from what your time frame is for your investment. 30 years until retirement and 30 years into retirement are two very different points in people’s lives.

Work with a professional advisor. Consulting with a professional can help you keep your emotions in check, ask questions and deliver insight you might not have thought of.

Relax. Rome wasn’t built in a day and neither is your portfolio. Wealth is built over time, and markets wax and wane.

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Sterling Raskie, MSFS, CFP, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, IL. He is an adjunct professor teaching courses in math, finance, insurance and investments. His blog is Getting Your Financial Ducks in a Row, where he writes regularly about investments, retirement savings and financial planning.

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