Imagine a situation where you must make one of two choices:
- Accept a guaranteed $50 gain or
- Opt for a coin toss with a chance to win either $100 or zero dollars.
Now let’s flip this around. Your two required choices are:
- Accept a sure $50 loss or
- A coin toss where you could either lose $100 or nothing at all.
In the first scenario, where the prospect of making money is on the table, most people will take the $50 sure thing. But in the second scenario, where it’s all about losing money, most people will go for the coin flip to avoid the sure loss even though they’re setting themselves up for the possibility of an even greater loss. The reason behind these decisions, according to behavioral psychologists, is people tend to feel more pain from a loss than they do joy from a gain.1
How human biases affect financial decision making
Behavioral finance researchers uncovered dozens of human biases that affect financial decision making. A few examples include, recency bias (believing that past performance will be repeated in the future), overconfidence (investors thinking one’s own financial skills are greater than the objective accuracy of those skills), and herd behavior (doing whatever a larger group is doing regardless of whether it makes sense or not). (See By The Numbers in this issue for more examples.)
Herd behavior, for one, may contribute to irrational market valuations and price rises. A recent example is Uber, the ride-hailing company. Uber went public on May 10, 2019 with a market valuation of just over $75 billion, even though the firm has continued to post big losses and has warned that it may not become profitable in the foreseeable future. As Uber compares its business to Amazon, which was suffering losses when it went public but eventually became profitable, fear of missing out on the next big thing has helped to drive interest in Uber, despite their losses.2
It’s not hard to see how these biases can cause investors to make irrational decisions. And since the markets are driven by the collective decisions of human beings, this behavior may lead to various market inefficiencies, including wild swings in securities pricing, market “bubbles,” and subsequent crashes.
Helping retirement investors overcome behavioral biases
The U.S. is facing a retirement crisis. A 2018 survey by the Certified Financial Planner Board of Standards (CFP Board) found that two-thirds of American households have less than $100,000 in retirement savings. Despite a generally strong economy, survey respondents were less confident about their retirement prospects than they were five years ago.*
To help participants save more, plan efficiently, and gain confidence, ABA Retirement Funds Program (the “Program”) administrators can encourage participants to check out the variety of resources available through the Program.
Simply becoming aware of inherent human biases can help investors tamp down irrational behavior and make better financial decisions.
For more on behavioral finance research and findings, refer to books such as Nudge by Richard Thaler and Cass Sunstein, Predictably Irrational by Dan Ariely, and Daniel Kahneman’s best-selling Thinking, Fast and Slow.
1. https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/loss-aversion/ Accessed July 25, 2019
2. https://www.cnbc.com/2019/04/30/uber-looks-almost-nothing-like-amazon-despite-its-investor-pitch.html Published April 30, 2019; Accessed July 25, 2019
3. https://www.cfp.net/news-events/latest-news/2018/11/15/new-election-night-survey-even-with-booming-economy-consumers-are-not-on-track-to-retire-on-their-terms Accessed June 21, 2019