In the traditional finance world, it is assumed that every investor is objective and makes rational decisions, thus making the markets efficient. But history shows that investors tend to make irrational decisions due to a variety of different biases and tendencies, which in turn make the markets inefficient. This is one of the key concepts in behavioral finance, and in this blog, we will be going over some of the most prevalent biases we see today.
Your advisor is likely familiar with behavioral finance, but as an investor, it’s helpful to be aware of potential biases affecting your investment decisions.
Behavioral finance considers the psychological influences that affect the financial behaviors of investors. It attempts to explain why investors sometimes appear to lack self-control, make decisions that don’t align with their financial plan, allow personal experience and other factors to override facts, and ultimately often act against their own best interest.
When large numbers of investors allow biases to affect their buying and selling behavior, it leads to stock market anomalies, such as significant unexpected rises and falls in stock price. So not only can biases affect your own personal outcomes, but economists and the financial industry pay close attention to how it affects the markets as a whole.
Let’s take a look at the various types of biases that can affect your investment decisions.
Confirmation bias is probably the most common tendency investors experience. It occurs when an investor has an opinion about something and does two things: first, they only look for information that supports their opinion, and second, they distort information that contradicts their opinion into something that supports their views.
A problem that can arise due to confirmation bias is that investors will only pay attention to positive information that reinforces their view and ignore negative information that disagrees with their view.
This probably sounds familiar, as it applies to anything — politics, religion, sports, marital spats — not just investing. People want to grasp for evidence that “proves” they are right and serves their agenda.
When it comes to investing, confirmation bias can lead to investors under-diversifying their portfolios and over-investing in one investment because of overconfidence in their decisions.
We’re all familiar with the phrase ‘hindsight is 20/20,’ but how does that apply to investing?
Hindsight bias occurs when an investor looks back at an event and believes that they had correctly predicted that exact outcome. Like with anything, it’s easy to think to yourself, “I knew that was going to happen!” after the fact.
This concept can have negative implications for investors and lead to overconfidence in their ability to “predict” events occurring. Predicting market events is nearly 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. 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 a recency bias mindset, investors 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. However, the market does eventually go back up, so by not investing, they have missed out on a great opportunity.
It’s like when one thing goes wrong in the morning, and you expect your whole day to go downhill after that. Sometimes it happens, but not always. You could have a big win by lunch and turn the whole day around.
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.
Regret Aversion Bias
Similar to loss aversion bias, regret avoidance bias occurs when investors take no action at all 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 could 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.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.