In the world of traditional economics, human beings are all perfectly rational, always crunching the numbers to choose the very best outcome. Whether buying the right car or house, choosing the best selection of brands to optimize price vs. quality on our grocery list, or investing in a portfolio that matches our goals—in theory, we should process all the available information, then make a decision that maximizes our happiness, or “utility.”
Unfortunately, humans are far from perfect in real life. We make subpar decisions all the time. We get wrapped up in our emotions, we buy and sell at the wrong time, and we frequently lack the complete information—and the advanced brainpower—it would take to be truly certain we are making the best decision.
As it turns out, there is an entire field of study devoted to how our actions differ from what we theoretically should do. Behavioral finance combines traditional economics and finance with a heavy dose of psychology to establish how people act in real life when making financial decisions.
There are a couple of key lessons that behavioral finance can teach us:
- As humans, we tend to experience quite a few universal decision-making pitfalls, which are known as “behavioral biases.”
- No one is immune to biases. While the exact mix of biases we exhibit depends on our own unique personalities and thought processes, everyone, from an inexperienced investor to a seasoned expert, experiences biases in one form or another.
You’re probably ready to see some examples, right? Below are four particularly common biases among investors.
1. Loss Aversion
When’s the last time your portfolio went down? Chances are, it was a more memorable experience than when your portfolio went up. If this sounds familiar, that’s loss aversion at work.
Loss aversion explains why people often hate losses more than they enjoy gains. In fact, research shows that the negative feeling of a loss can be twice as powerful as the positive feeling of a gain!
So what does this mean for your portfolio?
Well, you might find yourself shying away from risk in order to avoid loss, which in some cases, can be detrimental to your long-term investment success. It may cause you to hold on to losing stocks far longer than you should in the hopes of seeing them rise again.
Unfortunately, these kinds of feelings frequently cause us to buy and sell at the wrong times, or invest in a portfolio that doesn’t quite meet our needs.
2. Availability/Recency Bias
One of the brain’s best (and worst) features is its ability to form a cohesive story from insufficient information. Famed psychologist Daniel Kahneman’s once said, “You will often find that knowing little makes it easier to fit everything you know into a coherent pattern.”
In other words, the less we know, the easier it is to make up a story about it! So, in the absence of full information, we typically revert to the most recent thing we’ve heard on the news, or what our friends have said about investing.
Availability bias often leads people to estimate the probability of an outcome based on how easily they can recall an example of that outcome.
For instance, if you’ve been watching too much Shark Week on Discovery Channel, you might be inclined to stay away from the ocean for a while, even if the actual probability of a shark attack is next to zero.
From an investing standpoint, if you continue to read about the success or prospect of a stock, it’s easy to assume that stock is a “good buy.” However, picking a stock just because you read about it in the news isn’t a long-term investing strategy.
You should choose an investment based on solid research and an understanding of how the holding aligns with your goals, not just because you’ve heard a lot about it.
3. Confirmation Bias
People tend to be drawn to ideas and information that validate our existing ideas. For instance, we tend to consume news networks that align with our political beliefs. We also might only ask for a second opinion if we’re not happy with the first.
In the investing world, this bias can be particularly dangerous. Investors who assume an investment is going up might seek out similar opinions and point to economic data that supports their suspicion. Meanwhile, those who assume the opposite about the same investment can likely point to other data that corroborates their opinion.
Sadly, making investment decisions in an echo chamber can lead us to be overconfident, or to underestimate an investment’s potential for risk—a possible recipe for bad performance.
Nobody invests thinking they won’t beat the market, but in any trade, there is a buyer and a seller. Once the trade takes place, both parties have accomplished their goal, and they both think they made the right choice. But guess what... only one of them actually did.
When it comes to investing, many of us tend to think we know more than we really do. Our overconfidence leads us to try to “beat the markets” when really focusing on a long-term strategy in line with our goals is the way to go.
Likewise, some investors might underestimate risk or overestimate expected return. This can cause excessive trading, or lack of diversification, since we’re convinced that a choice few stock picks will do well.
Do any of these biases sound familiar?
If you recognize any of the above biases in yourself, kudos! Self awareness is half the battle, and you are certainly not alone. Luckily, biases can be overcome with discipline to prioritize long-term strategy and stay in line with your ultimate goals.
If you would like some help keeping your biases in check or optimizing your financial strategy, please don’t hesitate to give me a call.