When it comes to financial planning, most advice focuses on numbers and logic. The problem is, people are inherently illogical at times, especially when it comes to things as personal as your finances.
A more modern approach to financial planning that we embrace here at Plancorp is known as behavioral finance.
While this doesn't mean we're throwing out portfolio reports for therapy couches, it does mean that rather than fight against our natural tendencies as humans, we're planning alongside them to improve outcomes and satisfaction.
We understand that for all humans, most of life is lived inside our own heads. Our brains are creating our reality, by utilizing every experience we’ve had, all the information we consume, and running through algorithms and compressions to predict what will happen next.
For our brains to cooperate with our financial plan, we need to understand the biases that exist, and how we can work together with our clients to overcome them, rewire if need be, and make smart decisions with our money.
In this article, we'll unpack two important biases that we see cost clients the most. They are very similar, but can present in unique ways as you develop a financial plan.
Endowment Effect
The first bias we’ll explore is the Endowment Effect. Simply stated, the endowment effect is our tendency to over-value what we already own.
This particular cognitive bias, extensively studied in fields of behavioral economics as well as psychology, is deeply rooted in loss aversion, ownership, and identity.
You can likely relate to this feeling of the Endowment Effect in terms of buying or selling a house. As a seller, you estimate your home is worth more than it really is. You own it. You know the labor you and your family put into it, and you felt the pinch when the repairs had to be made and stole extra dollars from elsewhere in your budget.
Ownership has emotional impact. For all these reasons, your home is worth more in your mind than Zillow likely thinks it is – let alone a buyer.
This bias absolutely comes into play in financial planning. We commonly see this manifest in a few scenarios:
- When you get restricted stock units (RSUs) or other company stock
- When you were gifted stock or other assets
- When you have developed a stock concentration over time
In all of these scenarios, the ownership and identity components are speaking loudly in our minds.
Company stock feels special, precious, and we feel a sense of participation through our day-to-day contributions to the company. Our work is often a major component of how we see ourselves, of how we are perceived by others. If the work you do represents your values, your skills and strengths, your passions, it represents your identity.
Even for those who dislike their job, work still plays a major role in identity in terms of self-perceptions, and company stock awards may be something that the job feel ‘worthwhile.’
Similarly, gifted stock or real estate may carry generational weight – if your parent bought Apple stock at $1 a share, your parent can be defined as a success story and eventually needing to sell it can be a bigger emotional task than financial.
Concentrated stock positions can come about in a variety of ways including equity compensation or gifts as noted above, but it may also be through attachments to our own decisions from years ago. We feel similarly attached to stock we purchased as a child or young adult; selling it can feel like parting with an identity as a great stock-picker or proactive long-term planner. But just because you’re personally attached doesn’t mean it’s the best choice for your financial plan.
Here’s why: the company could be a huge success, allowing you to gain some liquidity and diversify your investments, or the company could fail fast before you put more into it.
But the most likely scenario is the company performance fluctuates with greater volatility than the market and/or begins to fail slowly while your emotional attachment drives you to sink even more cash in.
In short, the endowment effect can attach an anchor to your portfolio that is clear as day to anyone from the outside but near invisible to you. That makes it a dangerous gamble that even for highly successful companies can add unnecessary risk.
When I get asked if hiring a financial advisor is important, the endowment effect is one of the first things I bring up. A good, independent advisor, can help spot the invisible weights that may be dragging your financial plan and identify good solutions to address them that won’t negatively impact your tax bill.
Confirmation Bias
Confirmation bias is our tendency to look for more evidence to validate what we already believe instead of impartially evaluating facts to make good decisions. More to the point – we hear what we want to hear and disregard the rest.
I think the most terrifying example of confirmation bias is the story of the Challenger Space Shuttle. While there were many biases and interacting mistakes at play in this particular example (it’s a textbook example of groupthink), NASA engineers specifically demonstrated confirmation bias in not reviewing ALL launches, successes and failures, when making their decision.
Their sample sizes presented to NASA contained only a small number of O-ring failures – but the full universe of data on launches would have shown that O-ring failures occurred frequently at low temperatures, which is exactly what happened on that cold January morning.
I see confirmation bias in financial planning at play when clients:
- Want to engage in 'stock picking'
- Consistently refuse to sell stock or assets for something you "know more" about or are emotionally tied to (related to endowment, but possibly more ‘fact’ based)
- Struggle with introducing or enforcing financial boundaries with teenage or even adult children
As a Plancorp advisor, confirmation bias is one of the many reasons that stock picking is such a difficult thing to overcome. In fact, it may be an indication that our investment philosophy is misaligned, and we are not able to move forward with a client. At Plancorp, our investment portfolios are built using an academic-based approach, rooted in low cost and diversification.
Individual stocks can be a lot of fun to some investors, and as long as you’re not taking the risk of a concentrated position, it isn’t necessarily ‘dangerous’ – at least, no more so than going to the roulette table. However, for your whole portfolio, holding individual stocks rather than low cost diversified funds increases your risk as an investor, exponentially, without a corresponding increase in expected return.
Once some success has been had in picking an individual stock, this success is now part of our story, and we use one success as confirmation that we are always going to be successful.
As noted above, often stock of one’s employer feels different, as though there is some control or unique access to information due to our day-to-day involvement in the business.
For many years, unique knowledge may have been possible, but in today’s world of instant information shared worldwide, even the managers of active funds have very little ability to pick stocks to outperform the market average.
We also see confirmation bias in ways that are much more personal than the investments. We see it in parenting, no matter the age of the ‘children.’
Early on, a parent who believes their child is not ‘mathematically- minded’ might recall mostly moments of struggle, overlooking successes, and this can become a self-fulfilling cycle.
Parents who believe their children to be naturally gifted may attribute their success to talent versus hard work, and potentially create undue pressure on children.
Even when children are grown, parents may have the opinion that their child is ‘good with money’ or ‘bad with money.’
These belief systems, also often self-fulfilling, can influence the parent’s willingness to gift too much or too little. When an adult child or another family member or friend is in need of financial assistance, providing they help they need is fraught with risks.
Confirmation bias can stand in the way of making wise decisions. An example is the case of repeated gifting, when even 1 out of 5 times the recipient’s behavior has been grateful, they’ve maybe either paid back the money or at least used it very responsibly. While the disconfirming evidence can be right there, in those other four instances, we view the one example as the rule, not the exception.
Everyone’s Biased: How to Navigate Through It
Confirmation bias, working together with the Endowment effect, can have devastating results on a portfolio. Any one of these scenarios can derail financial success, and they’re not always even that easy to see.
If you aren’t looking at a summary of your net worth on at least an annual basis, you may have no idea that the inherited stock you got from your grandma is actually making up 40% of that net worth and it’s been slowly decreasing.
If you aren’t analyzing your financial independence, you may not realize that if your Company’s stock declines by 10% between now and your retirement, it will translate to thousands of dollars in reduced spending for your financial security to remain intact.
As advisors we seek to be not only aware of these biases, but to be skilled in navigating the resulting dangers, as well as to offer education and alternatives to our clients.
One of the most valuable ways we serve our clients is to be an empathetic accountability coach in moving past biases to achieve better outcomes.
Learn more about how we serve our clients through a comprehensive approach to financial planning and wealth management by exploring our helpful guide.
