My five month old daughter is just beginning to understand the concept of cause and effect. She is learning that when she shakes her rattle it will make a sound and that when she giggles mommy and daddy will make a big fuss. In these small ways she is starting to form her first conceptions about the world around her. These initial observations will create the foundation for the development of her very first habits.
While we have more control over our actions than a five month old, the reality is that our habits evolve in exactly the same way. When we observe a new phenomenon, our first instinct is to investigate. We want to determine what caused the effect. Once we determine the cause we choose how to respond. After many instances of the same sequence of cause, effect, and choice we begin to skip the investigation and simply react to the stimulus. We create a habit. These automatic responses allow us to move through our daily lives with relative ease, turning complicated processes into manageable tasks we can accomplish almost without thinking.
Generally, the ability to simply react to stimuli out of habit is a good thing. It has helped our species survive and allows us to move relatively unfettered through the routine of our daily lives. The trouble arises when our habits are formed from flawed investigations into cause and effect, resulting in “bad” choices and the development of “bad” habits. We can examine two common behavioral finance concepts, 1) Hindsight Bias and 2) Overconfidence, to see how a flawed choice can lead to a bad habit.
Hindsight Bias occurs when individuals believe that a particular event, e.g. the S&P 500 declining 8% in the first 15 days of the year, was predictable and completely obvious. Hindsight Bias is often attributed to our innate need to create order and predictability in an often random and unpredictable world. By drawing erroneous links between oversimplified causes and effects, e.g. the S&P 500 declined 8% because Price to Earnings (PE) ratios deviated too far from historical averages, we can trick ourselves into believing that the event had to occur and everyone should have seen it coming. Hindsight Bias is the leading cause of another dangerous bias for investors: Overconfidence.
Overconfidence in investing, overestimating or exaggerating your ability to successfully invest your portfolio, can lead to disastrous results. People’s reliance on their Hindsight Bias, e.g. PE ratios are getting high so that means the market will decline just like last time, feeds their Overconfidence, e.g. I will sell my equities because I know the market will decline. A habit then forms of constantly buying and selling positions in reaction to various market indicators, e.g. PE ratios, the moving average, consumer confidence, etc. This constant movement, entering and exiting positions in response to transient stimuli, typically leads to lower portfolio returns than the market generally.
Identifying our bad habits is only half the battle; we also need to know how to break them. Luckily, Hindsight Bias and Overconfidence can be defeated with a small dose of humility. We must admit to ourselves that we cannot accurately predict how capital markets will act. Rather than wasting time deluding ourselves that we are in control we should simply concede the point that capital markets are entirely unpredictable. That concession is not a defeat, but an opportunity to refocus our energy on the factors we can control, and to commit to forming new “healthy” habits. Habits like: 1) maintaining a diversified portfolio; 2) creating an asset allocation that is in line with our risk willingness and ability; 3) keeping that allocation through routine and systematic rebalancing; and 4) focusing on achieving our unique financial goals rather than “beating the index.”
Habits are neither created nor broken in a day, but through our consistent choices we can develop healthy habits that will aid us through a lifetime of investing.