Are You Your Own Worst Enemy When It Comes to Your Investments?
As humans, we all have instinctive behavioral biases that drive and influence our decision-making. It all stems from investor psychology; you may think that this doesn’t apply to money matters, but the fact is that for many of us, our emotions play a larger part than we realize in determining how we choose to manage and invest our money.
Behavioral finance is a field of study that focuses on our behavioral biases – the psychological factors that influence investor decision-making in the financial markets. Researchers in the field have discovered that there are many mental shortcuts investors use when they need to make complex financial decisions and, at times, they can end up clouding our judgment and leading us to make financial missteps.
Below we’ll dig into investor psychology, five common behavioral biases that can influence your relationship with money – and what you can do to keep them from derailing your financial success.
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Investor Psychology: What’s Behind Behavioral Biases in Investing
Investor psychology is the aspect of behavioral finance that studies the behavior of investors – what they believe, how they act, what they do, and why. When working with something as volatile as the stock market, it can be hard to keep emotional and behavioral biases out of our decision-making processes, and the results can be costly if we’re not careful.
When it comes to behavioral finance and investor psychology, there are two types of overarching biases that seem to consistently impact investors – cognitive bias and emotional bias. The tendency to think or act in a particular way or to follow a tried-and-true strategy that you’ve adopted throughout the years is a cognitive bias. Emotional biases reveal themselves as a tendency to take actions based on gut feelings or instinct rather than on the facts presented.
Even if you consider yourself a logical person, human nature makes us all a bit fallible when it comes to investor psychology. So, you may benefit from learning more about the cognitive and emotional behavioral biases below so you won’t fall victim to them.
Loss Aversion Bias
Loss aversion is a bias toward avoiding losses over seeking gains. This could potentially influence your decision to adjust the level of risk in your portfolio, out of concern that you might end up with a loss greater than your gains.
How it can hurt you: Loss aversion can lead investors to avoid risk altogether, and eschew diversifying their investments, even when some level of risk and diversification is needed to achieve goals in the end. Investing in a diversified portfolio can be a strategy to potentially build wealth over the long term. For those who are just starting out and have a longer time horizon, taking on risk may potentially lead to higher returns over time.
How to overcome it: Don’t let your emotions determine your investments. Instead, create a strong investment strategy that includes diversification and managing risk, and stick to it.
Overconfidence Bias/Self-Attribution Bias
This investor psychology bias can be difficult to admit you have because it requires acknowledging that you’re overconfident as an investor. Overconfidence bias is the tendency to see ourselves as better investors than we really are. Investors who suffer from this bias attribute successful portfolio outcomes to their own actions, but poor outcomes to external factors.
How it can hurt you: The most significant way that overconfidence bias can hurt you as an investor is that it can cause you to overestimate your abilities and knowledge, leading you to make poor or rash decisions not based on data or research. For example, if you think you can accurately time the market, you may find yourself in a bad spot because of how unpredictable and volatile the markets actually are.
How to overcome it: Active traders tend to perform more poorly over time than those who buy and hold, so make a mental effort to stick to passive investing instead. If you’re someone who’s confident in your abilities to navigate the world of investing, you might want to consider running your investment strategy by a professional to see if they have any advice they can offer about your strategy.
Anchoring Bias
Anchoring is when someone values an initial piece of information or a perspective too much to make subsequent judgments, and it’s one of the most common behavioral biases. Also known as confirmation bias, this bias impacts every part of our lives as humans because our brains tend to selectively filter information, paying more attention to things that support our existing opinions and beliefs. For investors with this bias, you may find yourself fixating on investment information that supports previous ideas, rather than keeping an open mind when you learn something new or hear conflicting information.
How it can hurt you: Investors are particularly susceptible to anchoring bias because most investment decisions require making complex judgments. An investor may find themselves holding onto a stock longer than they should because they’re too focused on one piece of information about it, such as its price being higher now than when they purchased it. However, staying too tied to the buying price is clouding their ability to see the stock value for what it is.
How to overcome it: Slow down and do your research before you make any decisions with your investments. Work to overcome your own investor psychology by actively seeking out information about an investment that contradicts what you currently think about it. Having a comprehensive understanding of an asset’s price, for instance, can help reduce the possibility of falling victim to anchoring bias.
Herd-Behavior Bias
Herd behavior happens when you follow what others are doing rather than making your own investment decisions based on facts or research. People often follow the crowd due to a perceived sense of safety, although this may not always be the case. This can also happen when you’re afraid of missing out on what others are doing, so you join in so as not to be left on the sidelines.
How it can hurt you: When you follow the crowd, there is a possibility that it may not work out as expected. Herd behavior in the markets can sometimes lead to the formation of bubbles, which have a history of eventually bursting. We saw this happen with the Dutch tulip market bubble, the Dot-Com bubble, and even the real estate bubble in the mid-2000s.
How to overcome it: Take your investment decisions seriously. Do your research, look at the facts, and decide what the best choices are for you, your unique situation, and your long-term financial goals – not the masses. Before investing in a company, look at its fundamentals and be sure you feel confident in making the move to buy in.
Investor Psychology and Behavioral Biases: The Takeaway
Admitting you have shortcomings is never easy, but we all have them. It’s human nature to fall back on certain cognitive and behavioral biases, so as an investor, chances are you’ll find yourself negatively impacted by a behavioral finance mistake at some point along your investing journey.
While understanding more about investor psychology and common behavioral biases can help you make better decisions, you’ll never be able to fully erase your biases. That’s why it’s so important to work with a financial professional you trust to build a wealth strategy and help you manage your investment portfolio.
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