How our behavioral biases affect our investment decisions
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We have all heard the adage, “Buy low. Sell high.” Seems rational, right? We all like to think that we are rational. Yet, more times than not, human nature tends to lead us do the opposite. And why is that?
There is a whole field of study know as behavioral finance that combines elements of psychology and economics to understand how human behavior and emotions influence financial decisions and market outcomes. It seeks to explain why investors often make irrational choices, deviating from the traditional assumptions of rationality and efficiency in financial markets.
In traditional finance, the efficient market hypothesis assumes that investors are rational and make decisions based on all available information. However, behavioral finance recognizes that human beings are not always rational and can be influenced by cognitive biases, emotions, and social factors. These biases can lead to systematic errors in judgment and decision-making, impacting investment choices and market dynamics.
There are several major biases that affect investor behavior. Here are some of the most prominent ones and how they can impact investment outcomes:
Confirmation Bias: This bias refers to the tendency to seek information that confirms pre-existing beliefs while ignoring or dismissing contradictory evidence. Investors affected by confirmation bias may selectively interpret information to support their initial investment thesis. This can lead to a lack of objective analysis and potentially result in poor investment decisions.
Loss Aversion: Loss aversion is the tendency to strongly prefer avoiding losses over acquiring gains. Investors who are loss-averse may be more inclined to hold onto losing investments in the hope of recovering their losses, even when it’s rational to cut losses. This can lead to a failure to take necessary corrective actions, resulting in further losses.
Overconfidence: Overconfidence bias refers to an inflated belief in one’s ability to predict future outcomes accurately. Overconfident investors may overestimate their investment knowledge and skills, leading them to take on excessive risks or trade more frequently. This can result in suboptimal investment performance and increased transaction costs.
Anchoring Bias: Anchoring bias involves relying too heavily on an initial piece of information when making subsequent decisions. Investors may anchor their valuations or expectations to a specific reference point, such as the purchase price of a stock. This can prevent them from adjusting their views based on new information, leading to missed opportunities or stubbornly holding onto outdated beliefs.
Herd Mentality: Herd mentality refers to the tendency of individuals to mimic the actions of a larger group, often driven by the fear of missing out or the belief that “everyone else must be right.” Investors influenced by herd behavior may make investment decisions based on the actions of others rather than conducting independent analysis. This can lead to the formation of market bubbles or panics, as well as a lack of diversification.
Recency Bias: Recency bias is the tendency to give more weight to recent events or experiences when making decisions. Investors affected by recency bias may overweight recent market trends or short-term performance, ignoring historical data or long-term trends. This can result in chasing past returns or reacting excessively to short-term market fluctuations.
It is important for investors to understanding how these biases influence their perception of the world and ultimately their decision processes. Keeping biases in check will help investors make more informed decisions and avoid costly mistakes driven by emotional reactions. Protecting against bias in investing requires self-awareness, discipline, and the implementation of certain strategies.
Working with a trusted and seasoned advisor is one way to insulate an investor from the emotional influences of unchecked biases. A good advisor can help develop a disciplined, long-term investing strategy and avoid impulsive and emotionally driven decisions by encouraging investors to focus on fundamental analysis, diversification, and maintaining a well-balanced portfolio.
Steven Young is a Senior Vice President of Wealth Management for UBS Financial Services. He is the team lead for the Business Transition Consultants based in Indianapolis, IN.