27
Independent Behavioral Investor Type

To find yourself, think for yourself.

Socrates

Name of Behavioral Investor Type: Independent

Basic Orientation: Engaged in the investment process and opinionated on investment decisions.

Dominant Bias Type: Cognitive, relating to the pitfalls of doing one's own research

Impactful Biases: Confirmation and Availability

Investing Style: Active

Level of Risk Tolerance: Generally above average but not as high as aggressive investors

An Independent behavioral investor type is someone who has original ideas about investing and likes to get involved in the investment process. Unlike Followers, they are not disinterested in investing, are quite engaged in the financial markets, and may have unconventional views on investing. This “contrarian” mindset, however, may cause Independents to not believe in following a long-term investment plan. With that said, many Independents can and do stick to an investment plan to accomplish their financial goals. At their essence, Independents are analytical, critical thinkers who make many of their decisions based on logic and their own gut instinct. They are willing to take risks and act decisively when called upon to do so. Independents can accomplish tasks when they put their minds to it; they tend to be thinkers and doers as opposed to followers and dreamers.

Unfortunately, some Independents are prone to biases that can torpedo their ability to reach goals. For example, Independents may act too quickly, without learning as much as they can about their investments before making them. For example, they may mistake reading an article in a business news publication for doing original research. In their half-ready, full-on pursuit of profit, they may leave some important stones unturned that could trip them up in the end.

Independents' risk tolerance is relatively high, and so is their ability to understand risk. Independents are realistic in understanding that risky assets can and do go down as well as up. However, when their investments fall they don't like to admit that they were wrong or that they made a mistake (sound familiar?). Independents often do their own research and don't feel comfortable with an investment until they have confirmed their decision with research or some form of corroboration. They are comfortable collaborating with advisors, though typically using those advisors as sounding boards for their own ideas. Independents are often comfortable speaking the language of finance and understand financial terms, including market- and economic-related terms. They aren't afraid to delve into the details of investments, including the costs and fees of making investments.

Schematic illustration of the Independent Investor Type Characteristics.

Figure 27.1 Independent Investor Type Characteristics

Biases of Independents are mainly cognitive: conservatism, confirmation, self-attribution, availability, and representativeness. These biases and risk tolerance level are depicted in Figure 27.1.

What follows is a brief analysis of the positives and negatives of the Independent BIT (called Upside/Downside analysis), a description of the biases just discussed and how the biases relate to the Independent BIT.

Upside/Downside Analysis

Upside: There are certain benefits that accrue to Independent BITs. At their essence, Independents are cerebral, strong-willed, independent thinkers who aren't afraid to put their investment ideas into action by implementing them in their portfolios. Successful investing requires the fortitude to not only have original ideas but also be able to put them into action when called upon to do so; Independents can take risks and act decisively. Independents can also be contrarian investors and can be very successful as there are many investors who are herd followers and are often not happy as a result. As they are analytical by nature, they may help themselves by finding the lowest-cost service providers. They tend to be thinkers and doers as opposed to followers and dreamers.

Downside: The downside to the BIT has mainly to do with biases that can torpedo their ability to reach their financial goals. As we will see in the next section, Independents can act too quickly, without taking the time to learn as much as they can about their investments before making them. They may also seek information that confirms their decisions as opposed to finding information that may contradict their hypotheses. The Independent may also irrationally cling to self-generated ideas, rather than take on board new ideas that may prove they are wrong. Their analytical nature may work against them at times. For example, some Independents may focus too much on taxes and not enough on selecting an appropriate investing strategy. In industry parlance, this is known as letting the “tax tail wag the investment dog.” The next section reviews these shortcomings in detail.

Bias Analysis of Independents

The main objective of any investor should be to stick to a plan and, much as it is with the other types, Independents can allow their biases to impede their ability to do so. Two of the most impactful biases of Independents are Confirmation and Availability. These will be reviewed now.

Confirmation Bias

Bias Type: Cognitive

Application to Independent BIT

People tend to want to stand by their decisions. It's human nature. And because it makes us feel good to believe we've made the right decision, we also tend to notice those things that support our decisions and opinions and ignore those that may contradict them. That's the essence of Confirmation Bias. It convinces us that what we want to believe is correct by mentally giving more weight to the factors that support our desired outcome. This behavior can be hazardous to one's wealth because we can be blindsided by facts that we did not consider. Confirmation Bias affects the investor by making an investment decision appear better than it actually is. An example from the last investing cycle provides a useful illustration.

Suppose an investor, Jack, who is 43 and single was an aggressive accumulator of oil and gas assets in the early 2010s. Over those years he had seen private equity and others buy up energy assets: for that reason, he believed that energy stocks would be his ticket to riches. His Confirmation Bias had been enforced year after year as fracking became popular and energy prices rose. He read article after article about the energy boom. There were economists and naysayers with differing opinions out there but he did not seek any contrary opinions. His Confirmation Bias clouded his judgment. It caused him to block out potential pitfalls and focus only on the good aspects of his investment. Like many people, he saw only the upside of the shale oil boom; he didn't see it as a bubble that could possibly burst.

Because investors with Confirmation Bias tend to seek out only information that confirms their beliefs about investments they have made or are about to make, they don't grasp the full picture, like Jack. He may have been peripherally aware that bad loans were being made, that the inventory of new energy was starting to outsize the demand—both factors that should have been as valid in informing his decisions as the others—but he was able to talk himself out of their importance, rationalizing that only certain oil patches were being affected.

Unfortunately for Jack, and so many others who got swept away by the energy boom of the last decade, Jack's portfolio, so heavily weighted as it was to energy, took a nosedive when the market crashed. Had he been aware of his Confirmation Bias, had he chosen to see outside the realm of what he wanted to be reality, he may not have lost so much.

Availability Bias

Bias Type: Cognitive

Application to Independent BIT

Another bias that weighs heavily on the investment decisions of Independents is Availability Bias. A cognitive bias, Availability makes investors believe that the facts most relevant to their own lives are the ones most relevant to the success of an investment. How “available” information is to them thus somehow determines how reliable it is. When one has this bias, the possibilities that we can easily recall, that we are most familiar with, seem more likely to be true than those that are less familiar. With all the information that comes at us every day, it's so difficult to properly process it all. For that reason, we process bits of information we can easily identify and swallow, and ignore the rest.

When it comes to investing, this behavior usually translates into judgments based on past experience and easily perceived outcomes, instead of taking in harder-to-grasp data, such as statistics. Some people put a subjective slant on information rather than look objectively at the cold, hard facts. A classic example is investing with those brokers or mutual funds that do the most advertising. These firms make information available and people buy them; but are they the best? Diligent research might prove otherwise.

The following is a simple quiz for Availability Bias.

Please answer the following:

  1. Which do you believe is more likely, death by stroke or death by homicide?
  2. What about death by falling airplane parts or death by shark bite?
  3. Does the letter K appear more often as a first letter or a third letter in the English language?
  4. Which claims more lives in the United States: lightning or tornadoes?

Evaluation

Question 1. Because death by homicide appears in the news more often than death by stroke, most believe death by homicide is more prevalent—even though death by stroke is actually 11 times more probable.

Question 2. Because shark attacks are so sensationalized, people believe they are more common, but death by falling airplane parts is actually 30 times more likely.

Question 3. The letter “K” occurs twice as often as a third than a first letter, but it's common to categorize words based on their initial letters.

Question 4. More Americans are killed every year by lightning than by tornadoes, but warnings, drills, and other publicity make tornado fatalities memorable.

Other important Independent Biases are: Self-Attribution, Conservatism, and Representativeness.

As we have just seen, Confirmation and Availability biases are two highly impactful biases for Independents. However, there are other biases that can be found to occur with Independent BITs with some regularity. These are Self-Attribution, Conservatism, and Representativeness. We will review these now.

Self-Attribution

Bias Type: Cognitive

When a decision we make works out nicely, we like to attribute the success to our own talents and foresight. And when things don't turn out as planned, we like to blame bad luck and other circumstances that are out of our control. If you score a high mark on a test, do you believe this to be a direct result of your hard work and innate intelligence—and if you do poorly, do you blame the grading system of the test? If you have a tendency to believe your successes have everything to do with your talents and abilities, and that your failures are never a result of your own shortcomings, then you probably harbor the Self-Attribution Bias.

When an Independent BIT's financial decisions pan out well, they like to congratulate themselves on their shrewdness. When things don't turn out so profitably, however, the Independent BIT consoles themselves by concluding that someone or something else is at fault. Neither is entirely correct. Oftentimes, when things work out well and people with a Self-Attribution Bias assess their portfolios, they end up having more confidence in their stock-picking abilities than is actually warranted—and, as a result, they may end up taking on more risk than they should. You've heard the phrase “a little knowledge is a dangerous thing”? In investing, it can be savage.

Winning investment outcomes are typically due to any number of factors, a bull market being the most prominent; stocks' declining in value, meanwhile, can be equally random and complex (sometimes due to fraud or mismanagement, sometimes to luck). Because they believe they have more control over these outcomes than is warranted, people with Self-Attribution Bias are consumed by the pride that surges when trades do well, and because they do not take a step back to figure out what they could have done wrong when trades fail, they tend to trade too often, resulting in a portfolio that underperforms.

Conservatism Bias

Bias Type: Cognitive

Independent BIT investors with a Conservatism Bias tend to cling to what they already know to be true at the expense of acquiring new information. The following example illustrates this. Suppose an investor named James receives some bad news regarding a company's earnings, which contradicts another earnings estimate from the month prior, which he relied on to invest in the company. Because he has a Conservatism Bias, James underreacts to the new information, holding on to the original estimate instead of acting on the new. As a result, he ends up holding on to a stock that he's going to lose money on because he refuses to see that he could. Like James, people with Conservatism Bias can make bad investment decisions because they are “stuck” in their prior beliefs.

Representative Bias

Bias Type: Cognitive

The last bias that can be attributed to Independents is Representative Bias. Like Availability Bias, Representative Bias is strongly rooted in our desire to have the information we need to process fit into a neat framework. But Representative Bias takes this tendency a step further: When someone with this bias encounters elements that don't fit into their categories, they try a “best fit” approach.

On the plus side, Representative Bias helps us quickly absorb and process new information; on the downside, it works against us as it only allows us to perceive those probabilities that fit into the framework of what we want to perceive. Think of the gambler on a “winning streak.” Statistically, there is no such thing as a winning streak, but try telling the gambler that when the odds are working in his favor. The gambler sees winning hand being played after winning hand, and forces this into a framework he can understand—the winning streak. But really, it's all just chance.

Advice for Independents

Independents are firm in their views due to their independent mindset, but they are usually grounded enough to listen to sound advice when it is presented in a way that respects their independent views. As we have learned, Independents are firm in their belief in themselves and their decisions but can be blinded to contrary thinking. As with Followers, education is essential to changing the behavior of Independents; their biases are predominantly cognitive, so commitment to a long-term plan is usually the best course of action. Independent investors should try to substantiate their investment decisions with data. Using data in clear, unambiguous ways is an effective approach. Taking this approach should yield positive results.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
35.169.107.177