In the traditional finance world, it is assumed that every investor is objective and makes rational decisions, thus making the markets efficient. As history shows, that is typically not the case! Investors tend to make irrational decisions due to a variety of different biases and tendencies, which in turn make the markets inefficient. This concept is called behavioral finance, and in this blog, we will be going over some of the most prevalent biases we see today.
The first bias, confirmation bias, is probably the most common tendency investors experience. Confirmation bias occurs when investors have an opinion about something and does two things: first, they only look for information that supports their opinion, and second, distorts information that contradicts their opinion into something that supports their views.
A problem that can arise due to confirmation bias can be that investors will only pay attention to positive information that reinforces their view and ignore negative information that disagrees with their view. This can lead to investors under-diversifying their portfolios and over-investing in one investment because of overconfidence in their decisions.
Hindsight bias occurs when an investor looks back at an event and believes that they had correctly predicted that exact outcome. This concept can have negative implications for investors and lead to overconfidence in their ability to “predict” events occurring. Predicting market events is near impossible, so recognizing that and staying objective is important when investing.
Illusion of Control Bias
The illusion of control bias occurs when investors think they can control or affect outcomes when in fact, they cannot. Like hindsight bias, the market is hard to predict and is uncontrollable! This illusion of control bias can lead to investors over-trading in the market or failing to diversify their portfolio.
Another common bias that investors may experience is recency bias. Recency bias occurs when investors remember and emphasize more recent events than those in the past. This tendency commonly occurs during market upturns and downturns.
For example, when there is a bear market, people think that the market will keep going up and they tend to forget about past market downturns. With this mindset, they keep buying risky investments, without diversifying into safer investments in case of a downturn. On the flip side, when there is a market downturn, investors think the market will stay down and so they reduce the amount of risk they take. When the market then goes up, they missed out on a great opportunity to invest.
Loss Aversion Bias
Loss aversion occurs when an investor feels more grief when they experience a loss than they feel pleasure when experiencing an equal gain. By feeling more emotional over a loss, these investors will likely be too afraid to act because they don’t want to risk having to experience and feel a loss. This can lead to holding on to losers too long and selling winners too quickly in the market.
Regret Aversion Bias
Similar to loss aversion bias, regret avoidance bias occurs when investors take no action because they are too afraid of doing something wrong. This can lead to investors having excess conservatism, missing out on opportunities, and risking the ability to meet their goals.
While it may be hard to keep our emotions in check when it comes to investing, keeping in mind these biases and how they could be impacting our decisions can be helpful.
If you have any questions about how behavioral finance can be impacting your investment decisions, please reach out to us. This information is not intended to be a substitute for specific individualized advice, and we suggest you discuss your specific situation with a qualified financial advisor.