Investing is both an art and a science, where rational decision making should ideally prevail. However, as we all know, humans are not always rational beings, and emotions, such as fear and greed, often trump our rational thinking and dictate our actual real-world responses. Whether we like it or not, our thought processes and actions are often influenced by various emotions, or preconceived ideas, which in the realm of finance and psychology are called “behavioral biases.” These biases can, and often do, lead to poor investment choices. In this blog post, I will explore some of the more common behavioral biases that I see on a day-to-day basis and discuss some strategies to employ, in order to help avoid falling prey to them.
One of the most prevalent biases in the world of finance and investing is called “confirmation bias.” Confirmation bias occurs when investors seek out information that supports their pre-existing beliefs, while ignoring contradictory evidence that does not match their expectations. A good example of this, is when we do a Google search on a specific topic and instead of reading and evaluating all of the relevant source material with an open mind, we simply read only the articles that support what we already believe to be true, instead. Sadly, this is what most of us do when we say we are doing “research.”
To help overcome confirmation bias, it is crucial to actively seek out and pay attention to diverse perspectives and engage in critical thinking (yes, even if it means listening to Fox News.) You must be willing and able to conduct thorough research, challenge your preconceived assumptions, and consider both positive and negative aspects before making investment decisions. While this may seem easy, in practice, it is often very hard to do.
Overconfidence bias leads investors to believe they possess superior skills or knowledge, which often leads to excessive risk-taking and unrealistic expectations. This is one of the biases that I most often see at work in my practice. I have noticed that this bias is most likely to rear its ugly head when working with highly-educated individuals with powerful and demanding professions, such as attorneys, engineers and physicians. These people often spend their days telling others what to do and why, and doing so with confidence and authority. So, when it comes to investing, these same individuals automatically assume they know what is best as well and are not shy to point this out to anyone within hearing distance. However, this is not what I have found to be the case at all. It seems that the more educated and high-powered one is in their career, the worse investor they are likely to be.
To mitigate overconfidence bias, it is important to maintain humility and recognize the limitations of your knowledge. You must be willing to listen to experts in the field, and practice a disciplined, systematic and methodical approach to investing. The wonderful thing about the stock market, and what makes it work in the first place, is that nobody has enough superior knowledge to regularly make superior profits. There are millions and millions of investors, making their best bets as to what the markets will do each day, and this information is constantly updated and reflected in current market prices and performance. Investing is one of the disciplines where the most important thing to know–and acknowledge–is what you don’t know.
Loss-aversion bias stems from our natural inclination to avoid losses. It has been shown in many studies that, for most investors, the fear and pain from suffering a loss is much greater the joy or pleasure received from a potential or actual gain. Due to this bias, investors tend to hold on to losing investments longer than they should, hoping for a recovery. Clients or prospects will often tell me that they are invested in a stock or fund that they no longer believe in, but that they want to wait until the share price at least recovers to their original purchase price before selling. However, In reality, every day that you hold a stock (or any investment), you are making a decision that you think there is more upside than downside potential at the current price. If you bought a stock at $100, and now it is down to $75, by holding the stock, you are in essence saying that you would be willing to buy the stock at $75, because you think it has good upside potential at this price. If you would not be willing to buy the stock at $75 at this point, then you shouldn’t continue to hold it just because you happened to pay more in the first place. Remember, what you paid for a stock has absolutely nothing to do with what that stock is actually worth. If you think the stock is a good buy, then hold it; if you don’t, sell it, and disregard anything that has to do with what you originally paid for it or expected to happen.
To counter loss-aversion bias, that is, you need to set clear investment goals and establish predetermined exit points or stop-loss orders. Regularly review your portfolio, objectively evaluate performance, and be willing to cut your losses when necessary.
Herd-mentality bias arises when investors follow the crowd without conducting independent analysis. This behavior often leads to market bubbles and irrational exuberance. This is also often referred to as “Fear of Missing Out (FOMO).” It often feels as if everyone else is doing so well in a particular stock or industry, that we better get in as well, so that we are not left behind. However, as our parents always asked us, “If Johnny jumps off a bridge, does that mean you should as well?”
To avoid getting caught up in herd-mentality bias, focus on your own investment objectives and conduct thorough due diligence. Make investment decisions that are based on sound fundamentals and long-term prospects, rather than short-term market trends or hype. Surround yourself with a network of trusted individuals who can provide diverse perspectives, listen to these people with an open-mind, and never ever try to “keep up with the Joneses.”
The final bias I want us to consider is called “recency bias.” Recency bias causes investors to place disproportionate importance on recent events or trends, while neglecting historical long-term precedents and patterns. This bias can be summed up with the popular idiom that states that we often “…Can’t see the forest for the trees.” Anyone who got caught up in the internet craze of the early 2000s knows this one well. When we are in an exciting or scary time period, it is easy to get caught up in the hype and hyperbole of the moment and not really grasp the long-term reality of a situation. However, in life, and especially in investing, it is crucial to step back and take a more holistic long-term look at things based on the long-term prospects, not the short-term excitement. Remember, one of the most dangerous phrases in investing is, “it’s different this time…”
To combat recency bias, investors must adopt a long-term investment mindset and focus on the underlying fundamentals. Maintain a balanced portfolio that aligns with your risk tolerance and investment objectives and don’t make knee-jerk changes based on current events and news headlines. Regularly review historical data to gain perspective, and avoid making impulsive decisions based solely on recent market movements.
Navigating the world of investing can be challenging, but understanding and overcoming behavioral biases is a critical step towards making sound investment decisions. By recognizing and actively addressing behavioral biases like confirmation bias, overconfidence bias, loss- aversion bias, herd-mentality bias, and recency bias, you can improve your chances of achieving long-term investment success. Cultivate a disciplined approach, seek diverse perspectives, and continually educate yourself to avoid falling prey to these biases. Remember, successful investing requires a rational and objective mindset, supported by thorough research and a focus on the long term. And, most importantly, remember, “Don’t Believe Everything You Think.”
We are not tax-experts and are not offering tax-advice here. Please discuss all tax matters with your tax-consultant and/or attorney before making any decisions.
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