Michael O. AdairManaging Director, Senior Investment Consultant | 2018

Emotional Errors

Emotional errors arise as a result of attitudes or feelings that cause the decision to deviate from the rationality assumed in traditional finance.

Emotional errors arise as a result of attitudes or feelings that cause the decision to deviate from the rationality assumed in traditional finance. While these are more difficult to fix than cognitive errors, it’s important to understand how emotions can influence investor behavior.

Endowment Bias

Endowment bias refers to peoples’ tendency to ascribe more value to items they own simply because they own them. For instance, people will pay more to retain something they already have than to obtain something that does not belong to them, even when there is no cause for attachment.35

In finance, this bias can lead to investors keeping certain assets because they are familiar, even if they become unprofitable or are inappropriate.

Loss Aversion

As mentioned in “The Origins of Behavioral Finance” section of this paper, loss aversion is the most salient feature of prospect theory. Simply put, it’s a person’s tendency to prefer avoiding losses to acquiring equivalent gains.37

Overconfidence

Many investors tend to overestimate their analytical skills and misinterpret the accuracy of their information. This is particularly true in the internet age, where access to so much information can lead to the illusion of knowledge. Overconfidence may lead to individuals taking on too much risk, under-diversifying portfolios, and trading too frequently.

Regret Aversion

Regret aversion occurs when people fear that their decision will turn out wrong in hindsight and is associated with risk aversion. Regret is a negative emotion, and anticipating it may affect behavior as people strive to eliminate or reduce this possibility. People are particularly likely to overestimate the regret they will feel when they miss a desired outcome by a narrow margin.38

Self-Control Bias

When people fail to act in pursuit of their long-term goals because of a lack of self-control, this is known as self-control bias. For instance, people may consume more today at the expense of saving for tomorrow. Self-control bias can also be described as the conflict between one’s long-term goals and one’s ability to pursue it due to a lack of discipline.

In investing, this can manifest in savings behaviors—such as the ability to save for retirement.39

Status Quo Bias

Status quo bias refers to the tendency to prefer that things to stay the same. In other words, people prefer to keep things the way they are because “it’s always been this way.” In investing, this can manifest in concentrated stock positions or the tendency to remain invested in assets that may no longer be appropriate for their portfolio.

Emotional errors arise as a result of attitudes or feelings that cause the decision to deviate from the rationality assumed in traditional finance.

Sources

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Important Disclosures

Investment management services provided by City National Bank through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor.

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.

Past performance is no guarantee of future performance.

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