Behavioral Finance (part 3 of 5): Looking at the Way Your Thinking and Behavior Affects Your Investing

Ron Wright |

Part 3 in a series of 5.

So far in this series, we have looked at the first four problematic financial behaviors. These are ways that investors behave at different times that can negatively impact their investments.  In this installment, we’ll take a look at three related behaviors: Reference Point, Representativeness and Familiarity.

Problem: Reference Point

Most of us are familiar with the concept of a reference point, but in the positive sense.  To illustrate, imagine you are in a rowboat and need to cross a lake.  When you are rowing, you are normally facing the opposite direction from the way you are traveling, so it can be very difficult to navigate in a straight line from one side of the lake to the other.  In order to keep yourself in line, you can pick a reference point on the shore that you are leaving.  So long as you keep this point in the correct perspective, then you can be assured of traveling in a straight line and getting across the lake with as little difficulty as possible.

In investing, a reference point works in much the same way, but can do more to lead us astray than leading us to the right destination.  In investing, a reference point generally occurs at a high or low point in value or on a specific date.  For instance, we often reference the value of an account as of the first of the year, and then speak about returns from that point forward. 

The problem with this is when we create reference points not only out of arbitrary dates, but also out of high and low price points.  For example, imagine you purchased a stock in January of 2015 at $25.  This stock appreciated considerably and closed out the year at a price of $50.  By the end of 2016 however, the stock fell upon harder times and dropped back to $45.  Depending upon the investor’s reference point this could be viewed as either an 80% gain ($25 rising to $45) or a 10% loss ($50 falling to $45). 

Having the wrong reference point could easily put the investor off-balance and subsequently cause bad trades to take place.  Consider that the 10% loss perspective could cause the investor to become unduly risk averse and lead him to become too conservative in his choices.  It could also keep him from selling the investment at a gain now, choosing instead to wait for the price to climb back up once again, which it may not do. 

Using a high or even a low price as a reference point to guide trading decisions has other ramifications as well.  If an investor wants to own a stock that has just moved above its 52-week high, he may go ahead and buy the stock at that high price for fear missing the boat while it zooms even higher.  The same can be said for selling a stock near its low price. Either way, the focus is taken off of the fundamentals of whether or not it is a good investment and shifted solely to where prices are relative to the reference point.

Problems:  Representativeness and Familiarity  

Representativeness and Familiarity both work in a similar fashion.  In each case, they cause investors to jump to a conclusion before all of the information and facts have been uncovered.  Most times, representativeness occurs simply because of the vast amounts of information that are available to be reviewed.  The human brain simply cannot process all the available data, so it takes short cuts based on past experiences or biases.  A classic example of this is the following riddle:

A highly skilled chief surgeon is summoned to the operating room to help with an emergency.  A patient was in a car accident and needs immediate surgery to save his life.  The doctor rushes into the operating room and suddenly stops short, exclaiming, “I cannot operate on this person, he is my son”.  However, the surgeon is not the boy’s father - how can this be the case?

Those who are familiar with this riddle already know that the doctor is really the boy’s mother.  In the minds of many people though, a male better represents the position of a highly skilled chief surgeon.  Thus, representativeness has caused our minds to jump to a conclusion without knowing all the facts.

Familiarity is closely related to representativeness.  With familiarity we allow our current knowledge of a thing or situation to influence our decisions about it.  In investing, there can exist a vast difference between a good company, or one with which we are familiar, and a good investment

Just because a company has a great product or service, and one that you know and enjoy, does not make it a great investment.  The quality of what the company produces is only one part of the puzzle.  The price of the investment is the other part.  There are many great companies that we can buy, but the price of those shares may or may not be justified by the fundamentals of the company itself.  However, familiarity with that company can lead us into thinking that it is always a great investment, and that can lead us to make a buy or sell decision at the wrong time without all of the necessary information.

The most obvious case of both representativeness and familiarity is during a market bubble.  During the dot-com boom of the late 1990’s, stocks were being bought solely on the basis of the representativeness of high-tech companies and familiarity with the goods and services produced by very successful ones, which had made a great deal of money for their early investors.  In many cases, these new companies had not yet produced anything, let alone generated a profit.   In order to support their buy recommendations, analysts began to rate these dot-com companies on the basis of actual and forecast sales revenues rather than realized net profits. Out of the fear of missing out on great gains, investors made the jump into these stocks without having considered all of the truly relevant information.  

Samuel Clements (aka Mark Twain) once wrote that it’s not what we don’t know that tends to get us in trouble, it’s the things we know for certain but that just ain’t so!  Clearly, the problem with all three of these behaviors, reference point, representativeness, and familiarity, is that they cause us to make decisions without understanding the big picture, thinking that we already have all of the information we need.  Taking these short cuts can lead us to make decisions which in the end can be downright disastrous.

Warren Buffet once compared investing to being up to bat in a baseball game.  Only in his version of the game there were no strikes, only balls and hits.  He asserted that the key was to have the patience to wait for exactly the right pitch, and not to swing at one just because you wanted to hit something.  You always need to make sure you hit the pitch that will go the farthest for you, even if it means missing a few that are ‘pretty good’ in the process.  The market will always throw you another good one if you just have the patience and focus to keep looking for it.


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