Is Bias Coming Between You and Your Investments?The human brain is a marvelous device, more powerful in terms of processing than many computers currently in existence. But there are limitations to our brains. Calculators can perform math computations faster and more accurately than our brains can, and most of us have experienced memory loss for any number of less than desirable reasons. In addition, as human beings, we are subject to cognitive biases which result in dubious decision-making and flawed conclusions.

A cognitive bias is defined as the inherent thinking errors that we humans make in processing information. Cognitive biases can be helpful when making a quick decision is more important than accuracy, such as recognizing a dangerous situation and taking the appropriate action to avoid physical harm. But cognitive biases can lead to errors in judgment when accuracy or acting in a logical fashion is essential. As investors, we should be aware of some of the cognitive biases or thought processes that can prevent us from investing rationally. Some of those biases that can affect our investment decision making processes are described below.

Biases Come In Many FormsConfirmation bias: We tend to search for information that confirms our ideas and dismiss data that doesn’t validate our point of view. As investors, it is critical that we see the pros and cons of an investment or strategy in order to evaluate that investment or strategy accurately.

In group bias: Similar to confirmation bias, we tend to favor and like those people who think as we do. We value their opinions while being suspicious of and dismissing the ideas of those who don’t. This bias may prevent us from exploring all aspects of an investment or strategy and may result in inaccurate decision making.

Gambler’s fallacy: We place too much importance on previous events, thinking that they will affect future outcomes. You’ve heard the following: past performance is no guarantee of future results. Just because an investment has increased in value recently does not mean it will continue to increase. Each investment or strategy must be analyzed on its own merits, evaluating all the data.

Post purchase rationalization: We make a purchase that we instinctively know is wrong but tell ourselves it was a great deal. This is a way to make ourselves feel better after we’ve made a bad decision. When an investor makes an investment that declines in value, rather than trying to justify the purchase by holding on and investing more dollars at a lower price, we should analyze the investment with an objective eye to determine whether or not the investment remains a good one.

Neglecting probability: We forget during a bull market that “a rising tide lifts all boats” and conclude that we are brilliant investors, when in fact we may not be. As a result, we may not properly assess a risk inherent in an investment or strategy. We might overstate an unlikely event (buying a stock because the company is a likely takeover target) or understate an unlikely event (an airplane crash). Making a large investment in an “unlikely” event is a long shot and not a prudent strategy to pursue.

Observational selection bias: We notice something we had not noticed in the past, and because we didn’t notice

it in the past, we assume the frequency has increased. Buying a new car and then

seeing the same car everywhere is an example of this bias. Is

Honda really sel l ing

m o r e

Accords (and therefore you should buy Honda stock), or are you just noticing the number of Accords on the road because you just bought a new Accord? This bias can result in our thinking that the appearance of those observations couldn’t possibly be a coincidence, but it probably is.

Status quo bias: We are creatures of habit and therefore are naturally resistant to change. This may influence our selection process and lead us to select only those investments that are aligned with our habits and routines. As investors, we must get comfortable with change because it is inevitable.

Negativity bias: We seem to pay more attention to bad news than good news, not because we like bad news better, but social scientists theorize it is because we think bad news is more important than good news. If you think this is not true, notice the types of stories on the local news tonight. Because of this negativity bias, we as investors have a tendency to pay more attention to the “bad” financial news rather than the “good” financial news. Two thousand twelve was a good example of the “bad” financial and political news dominating the airwaves. As a result, many investors did not participate in the stock market and missed the jump of the S&P 500 Index of 13.41 percent, the increase in the Dow of 7.26 percent and the advance in the NASDAQ of 15.91 percent.

Bandwagon bias: We have an instinctive desire to fit in and go with the crowd, but investing according to the conversations on social media sites, because Jim Cramer or someone we think highly of says so, is not the best way to make investment

Capital ConversationsJUNE 2013

Continued...Copyright 2013 REDW Stanley Financial Advisors, LLC. All Rights Reserved. This publication is intended for general informational purposes only.

The information contained does not constitute legal fi nancial, accounting or other professional advice.

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Neglecting probability: We forget during a bull market that“a rising tide lifts all boats” and conclude that we are brilliantinvestors, when in fact we may not be. As a result, we may notproperly assess a risk inherent in an investment or strategy. Wemight overstate an unlikely event (buying a stock because thecompany is a likely takeover target) or understate an unlikelyevent (an airplane crash). Making a large investment in an“unlikely” event is a long shot and not a prudent strategy topursue.

Observational selection bias: We notice something we hadnot noticed in the past, and because we didn’t notice

it in the past, we assume the frequency hasincreased. Buying a new car and then

seeing the same car everywhereis an example of this bias. Is

Honda reallysel l ing

m o r e

Accords (and therefore you should buy Honda stock), or are you just noticing the number of Accords on the road

Capital Conversationsdecisions. Fundamental analysis should be performed on each potential investment rather than making an investment based on fear or greed.

Projection bias: We project our thoughts and beliefs on others, unconsciously concluding that they think the same way we do or share the same thoughts, beliefs or positions, when in actuality, they may not. This can lead to overconfidence when predicting the outcome of a sports event or election or how a portfolio manager would manage an account.

Current moment bias: We make decisions based on the current moment without any thought given to what is best for us in the future. This type of decision-making has dominated our society for a number of years as evidenced by the nation’s low savings rates. Most of us would prefer to take our pleasure now and leave the discomfort for later, which is why it can be easier to justify buying that expensive new car or second home rather than saving for our children’s education or our retirement.

Anchoring effect: Also known as the relativity trap, we make decisions by comparing a situation to a limited set of information. It is called the anchoring effect because we anchor or base our decision by fixating on its relative value rather than its actual value. This could be an item (which we may not really need) that is on sale at our favorite store, and because the item is on sale and “cheap” relative to similar items in the store, we believe it is a good buy. In the investing world, it’s the same as thinking that an asset is cheap when compared to its peers or historical standard, while completing the appropriate analysis indicates the asset is not as good a buy as originally thought. This is also known as the “value trap.”

Overcoming these biases may be difficult and a challenge, but being aware of our human tendency toward these biases can make us better investors. The professionals at REDW Stanley can help you make smart investment decisions.

By Laura Hall, CIMA®, AIF® Portfolio Manager/

Chief Trading and Operations Officer

1. REDW encourages team members to give back to the community, whether by donating time or dollars. Although we do not have a total for the time team members donate to the community, we recently received information from United Way of Central New Mexico that the total gifts, both corporate and team member dollars, beginning with the 1998 campaign and ending with the 2012 campaign total $1,860,485.

2. Economic section: According to Yardeni Research, there were 17 times in the last 66 years that each of the first three months of the year have posted positive S&P 500 returns like we have this year. The average total yearly return for those 17 years was 20.2 percent, with NONE of those years posting a negative return.

3. Client section: For those of you thinking about a vacation home, one of our clients has a friend who is interested in selling her house and nine acres in the Bordeaux region of France. Anyone interested?

Did You Know?Did You Know?

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