Humans’ brains are not wired for disciplined investing. When people follow their natural instincts, they tend to apply faulty reasoning or let themselves be influenced by their emotions.
The Types of Biases and How to Differentiate Them
There are two types of biases: emotional and cognitive. Emotional biases are related to feelings and emotions at the time of decision, which are usually ingrained in the psychology of the individual and are generally harder to overcome. Cognitive biases stem from faulty reasoning and are usually easier to correct by being mindful of them and recognizing when they happen. We will review 12 of the most important biases in psychology and provide details on how to recognize and avoid them.
The Six Most Common Emotional Biases
Loss Aversion Bias
Humans in general tend to be loss avert. We are more upset about losing $50 than we are happy about finding $50. Same goes for investing, people tend to place more value on a loss than on a gain of the same size. To a biased individual, selling a stock at a loss and restructuring the portfolio might feel painful. Instead, they hold on to it in hopes that they will recover the loss.
Regret Aversion Bias
People exhibiting this bias tend to avoid making decisions out of fear that the decision might be wrong. Examples include not selling a stock out of fear that it might increase in value after selling.
The illusion of having superior information or ability to interpret data can lead to poor investment choices. Overconfidence leads us to believe we can spot the next winning stock or trend. This leads to little portfolio diversification or excessive trading, all of which go against the adequate long-term, disciplined, and diversified approach.
Lack of self-discipline in the short-term can lead to failure of long-term goals. People usually recognize the need to save for retirement, but sometimes the instant gratification from present consumption might cloud their judgement and lead to fewer savings than originally planned. Consequently, in an attempt to compensate for the lack of savings, investors suffering from this type of bias might accept too much risk in their portfolio to generate higher returns.
This refers to valuing an asset already held higher than if not held. This is often seen when a stock is inherited or has emotional value for the investor. Even if the position might not be the most suitable for the investor, they might refuse to sell.
Doing nothing rather than making a change. Humans are creatures of habit and that can be noticed in their investing patterns as well. Often, investors are resilient to change and tend to stick with current portfolios instead of researching new ideas.
The Six Most Common Cognitive Biases
Seeking data to confirm your beliefs instead of looking for contradictory evidence. People tend to look for data that validates their conclusion and stick with others that have the same opinions. A great example is thinking that a particular stock is a strong buy and then looking for research that proves that conclusion, while disregarding or putting very little weight on contradictory evidence.
The tendency to perceive events that have occurred as having been more predictable than they were. This leads investors to believe that they were able to predict an event and gives them the false impression that they can do it again in the future. Financial bubbles are great examples of hindsight bias, after they burst, when lots of analysts and market players say they “saw it coming”.
A phenomenon in which people do something just because others are doing it too. This bias is often called “herd mentality” and goes hand in hand with confirmation bias. Such behavior is often seen in bull market runs and asset bubbles, when investors tend to blindly follow the crowd, while disregarding or forgetting fundamentals.
The tendency to think that events or things that easily come to mind are more representative than they are. For example, investors may judge the quality of a stock based on a piece of information they just read in the news, ignoring any other relevant information. The ease of recalling an event makes the human brain perceive it as having a higher chance of recurring.
The erroneous belief that a certain random event is less or more likely to happen given a previous series of events. Let’s take the example of a coin flip. If we flip the coin 11 times and the first 10 times we get “head”, our natural tendency is to think there is a higher chance of a “tail” this time. These events are independent so there is a 50/50 chance for either option, but humans’ brains are wired to instantly think otherwise. Same concept applies to financial markets. After 5 days of markets going up, one could falsely assume that the market has a higher chance of going down on the 6th day.
Individuals feel they have more control over outcomes than they have. It’s like the feeling that you are safer when driving then when you are the passenger or the feeling that if you pick your own lottery numbers you have a higher chance of winning versus when they are randomly assigned. Illusion of control leads investors to frequent trading and under-diversification, which erodes portfolio performance.
For us, the most important thing is peace of mind for our clients, along with successful investment management and financial planning. By recognizing some of the mental and emotional errors humans are prone to, we can more easily mitigate or work around them while seeking the best outcome.
Check this post for another great read on mindfulness and long-term financial success.