Behavioral biases play a role in the decisions we make about how to invest. Of the vast amount of literature on the subject, we were struck by Professor Craig Fox’s comment from a 2014 interview on how behavioral biases can affect the way investors use (or do not use) their company-sponsored 401(k) plans to save for retirement.
Fox responded, “The decisions they make when they first become eligible — whether or not to participate, how much to contribute, how to diversify, etc. — can cast a long shadow over their financial future.”
Below, we share an excerpt from the interview that summarizes typical investor behavioral biases:
What are typical behavioral biases, and consequences, you observe among individual investors?
FOX: University of California, Berkeley Professor Terrance Odean and his collaborators have found that traders tend to be overconfident — trading too often, selling stocks that would have performed better than the ones they subsequently purchased. We are biased toward purchasing “attention-getting” stocks that have made news recently. We tend to be more risk-seeking for assets that are worth less than we paid for them (so that we hold on to them longer than perhaps we should), and we tend to be more risk-averse for assets that are worth more than we paid (so that we are more apt to sell them prematurely).
My colleague Shlomo Benartzi and his mentor Richard Thaler have found that investors tend to diversify in naïve ways. They are biased toward even allocation of their savings to each of the assets under consideration, without sufficient attention to how they are diversifying.1 Additionally, Benartzi and Thaler have argued that long-term investors are myopic in evaluating their returns.2 And because we are all more sensitive to losses than forgone gains, this causes many long-term investors to underinvest in more volatile (but faster-appreciating) assets. Also, investors tend to be biased toward holding assets that feel relatively familiar — such as company stock and domestic equities — which leads to insufficient diversification. I could go on.
1. Richard H. Thaler and Shlomo Benartzi, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving.” Journal of Political Economy 112, no. 1 pt. 2 (2004), S164–S187.
2. Shlomo Benartzi and Richard H. Thaler, “Behavioral Economics and the Retirement Savings Crisis.” Science 339 (March 2013), 1152–1153.
Source: Ashish Shrestha, “Countering Behavioral Bias.” DC Dimensions, Dimensional Fund Advisors, Summer 2014.