8 investor biases to avoid – don’t be your own worst enemy!
While we’d all like to think that we are capable of handling the stock market on our own, investor biases play a big part in interfering with our ability to do so. Don’t let them! This article covers the eight major psychological investing biases that get in our way, and what to do about each one.
What is an investor bias?
A bias is defined as a strong preconceived notion. It can be in favor of or against a particular person, place, or thing.
An investor bias is defined as an inclination about a particular aspect of investing (a security such as a stock or bond, the market, a particular type of investment style, etc.). Often these biases are the root cause of behaviors that investors have, and actions they may take.
Humans are living, feeling beings and under stress we can be subject to our emotions, making decisions that are counter to our logic, that we would not have made in a more composed state of mind. As markets and life events can never be predicted, it is a matter of time until we are faced with situations that tempt us to conform to our inner psychological flaws.
Why behavioral biases are so damaging to investors
It may not seem like a “thing”; but it is.
Investor bias is harmful because of its impact on investment performance. According to a Dalbar report, the average stock investor underperformed the index by 5.35% in 2019 (Dalbar, 2020).
If you’re reading this and doubting that the figure is accurate – well, then that’s just another example of how we can lack objectivity when faced with the cold, hard facts.
So before you devote any more time to debating…
Investing is emotional, and emotions vary like the wind. They are hard to quantify. I’m sure there are just as many studies proving the opposite, and there may be validity to dissent about this statistic – but that’s not really the point of this article. No matter what the investing population does, your only concern is you. And that’s where we can provide insights that may help you overcome investor biases that you may be having.
Let’s talk about those instead, shall we?
Alphabetically-arranged list of investor biases and how to overcome them
The list of investor biases is long. We’ve organized them in alphabetical order, because we like to keep things tidy on our blog.
Action bias
When faced with a shocking market event, there is a penchant to take action, and it doesn’t always work in the investor’s favor. This is called action bias.
Did you know that, according to Dalbar, about 70% of investor underperformance has happened over ten periods, and each of those periods was a time when the market was a major decline? (Dalbar, 2020)
Go ahead and roll your eyes – oh no, now they’re citing that Dalbar report again!
It may be or may be completely accurate in your case, but you’ve got to admit, there is a sneaking tendency to want to cash out instead of watching your hard-earned money sink in to the red tick marks zone.
How to overcome it: There are mantras and emotional training tools you could use to keep your emotions in check. However, we do believe the best remedy is to work with a financial advisor who can behaviorally coach you through these times.
Also try pausing and asking yourself, “Do I really need to sell at this precise moment, or is there any possibility that I am able to hold out and wait for the market to come back?”
Anchoring bias
Imagine this scenario.
You love baking strawberry shortcake in the summer, and to do that you need to buy strawberries. Now, the price of this food follows a very distinct seasonal pattern. In the summer, there is a higher quantity of strawberries produced, causing there to be a lower scarcity for the product available – prices fall. However in the late fall/early winter, prices rise sharply due to scarcity.
Let’s say you don’t know all this. Although you usually make strawberry shortcake in the summer, you get inspired in the midst of shopping for your New Years Party. “What? Three dollars for a pound of strawberries – I’m never buying these again!” you say.
It’s anchoring bias. You’re used to paying $1.37 for the same food. You swear off of strawberries without looking at what the price is at the time when you usually consume it. It’s a classic case of shortsightedness; you’re only analyzing the most recent information presented to you instead of looking at the overall picture.
This type of investor bias happens in the market all the time when investors create their expectations for what they think returns in their portfolio should be.
Let’s say you are in a secular bull market. Every year your portfolio returns 10%. Then the Fed hikes interest rate and the economy falls into a recession. Now you’re in negative territory for the year thinking it’s a crisis. You’re anchored to the most recent negative return and comparing it to the high returns of years past, failing to recognize that in the long term, this average return of the market is neither negative nor 10% but somewhere in between.
How to overcome it:
Ask yourself, “Am I being too short-sighted? What long term information am I overlooking that could possibly change my perspective?”
Confirmation bias
It’s a human trait to gravitate towards things that make us feel good, and avoid things that don’t. When investing, it’s easy to selectively weed out data that does not concur with beliefs we may have. This is the essence of confirmation bias.
Let’s say you are a big fan of cryptocurrency. You open your browser and the first three articles you see published on the internet are about the risks of investing in crypto, and how volatile it can be. Despite these signs of caution, you move ahead with your bullish stance.
Sadly, most of the great crashes in the stock market history would have been predicted if participants had just paid attention to the obvious signs. But they didn’t see it coming (as they should have) because of their blind spot.
Confirmation bias is to blame.
How to overcome it:
As with many other investor biases, the best remedy is to work with an objective third party, such as a financial advisor. One of the benefits is that in scenarios like this, a financial advisor will bring to your attention the information you are overlooking; and sometimes just that nudge is enough to help you from veering off course.
Disposition bias
Picture this.
You hold a diversified portfolio which contains two stocks of note.
- Stock A has a 25% loss, and the prospects for future performance are not good. The management team is stagnant and the product they sell is obsolete.
- Stock B has a 25% gain, and it has a bright future. The CEO was just replaced with a more suitable one, the company restructured and profit margins are rising, and the industry is expected to grow rapidly in the next 5-10 years.
You sit down for your quarterly review, and upon a quick glance you decide to sell the one with the gain. It’ll be great to pocket the gain to offset other losses in my portfolio, you say.
On the other hand, you are too skittish about recognizing a loss to sell the stock that is in the red. The pain of seeing the loss of dollars locked in prompts you to hope and pray that somehow the stock turns around and sees better days.
Disposition effect is a real investor bias, folks.
How to overcome it:
Making intelligent decisions about when to sell a stock is something that most investors don’t pay enough attention to. As we’ve mentioned before, one of the advantages of working with a financial advisor is that an unemotional third party can advise on the proper sell methodology.
If you opt to go your own route, have a discipline that applies to your sell decisions. What criteria do you look for in deciding to keep or sell a position? Write it down and revisit it on a regular basis, and certainly as you review your portfolios.
Familiarity bias
With a broad universe of securities to invest in, and a long list of Wall Street shiny objects constantly touted by the media it’s easy for investors to feel overwhelmed. One natural reaction is to stick to what is familiar and exclude the full set of investment options.
This type of investor bias plays out in various ways, from the style in which we manage our portfolio, the stock or bonds we buy, and even the investment decisions we make. Investment decisions should come from a sound, repeatable process incorporating elements such as risk assessments, research, valuations, and economic or market forecasting; not just a feeling.
Take a hypothetical example. Let’s say you are a gastroenterologist and through your work you become familiar with the ins and outs of various gastrointestinal remedies. You invest heavily in pharmaceutical stocks that could benefit from these trends, incurring a concentration in one or two stocks.
Now suppose regulators put up resistance to drug development, and your portfolio takes a hit – which it may or may not recover from. You thought you felt safe by sticking to what you knew – but the reality was you were exposing yourself to massive risk.
Seeing the big picture is important for all investors. Familiarity bias is harmful because it can lead to improper portfolio diversification and failure to protect from various risks (geopolitical risk, economic recession, inflation).
How to overcome it: Form a thorough investment process and write it down. Follow it every time. If you are unable to do this on your own, consider hiring a financial advisor.
Loss Aversion
Loss aversion is the psychological incongruity between the experience of loss and that of gain. The lows of feeling a loss are stronger than the highs of experiencing a gain, even if the two amounts are completely equivalent.
Loss aversion plays out in investing in a few different ways. This investor bias may cause you to hold on to a stock longer than you should, just to avoid recognizing the loss. It may lead you to sell down to cash if you fear the market is going to take a dive.
There are some pretty significant consequences when it comes to investment performance. According to the Quantitative Analysis of Investor Behavior 2019 study by Dalbar, the average investor in 2018 lost twice as much as the market (as cited in Charles Schwab, 2021). As there were a couple drawdowns over the course of that year, it’s presumable that investors did as described above – they either held on to positions they should not have, or sold when they shouldn’t have.
How to overcome it:
As loss version has deep emotional underpinnings, we believe the best remedy (as is for many other investor biases) is to work with a trusted financial advisor who can help you stay objective and exercise smart judgement during times of stress.
Self-attribution bias
Imagine the following scenario.
You undertake your quarterly rebalancing process, and having read an article about the value style, you decide to make some changes in your portfolio that involve a tilt towards certain value stocks based upon some research you did. The next week, you see that those stocks experienced a 20% gain. Patting yourself on the back for your hard work, you brag to your friends at the cocktail party about your investing skills.
Or was it luck?
Self-attribution is an investor bias that speaks to our ego. We’re way more likely to attribute positive outcomes to our hard work and skill rather than random chance or other factors that we are not responsible for. When things go wrong, we point the finger to others instead of ourselves.
It’s dangerous because it may lead us to wrongly perceive our true aptitudes and attempt tasks that we really shouldn’t be. All of this gets in the way of rational thinking.
How to overcome it:
As the Greek philosophers say, “Know thyself.”
It’s hard to remove your own pride from investing, but it’s important to see the truth. Careful analysis of the facts can often make this hard to ignore.
Trend-chasing bias
As Boys 2 Men once sang, “It’s so hard to say goodbye to yesterday.”
You can read every single disclaimer in the world, but human beings are naturally going to want to take an investment’s past performance into account when contemplating its future potential. And the financial media screaming about the latest “hot stocks” or “big movers” doesn’t help one iota. This is the origin of trend-chasing bias.
How to overcome it:
Process comes into play if you want to manage this investor bias. A thorough research process should entail an analysis of:
- Volatility
- Fundamental factors
- Correlations with other investments you may hold
- How this affects the overall risk level in your portfolio
- A buy and sell discipline
- What the risks specific to the investment are, and how to manage them
- What the costs of the investment are
If you’re not up for all the work involved with following a proper due diligence process for every investment you hold, consider working with a financial advisor.
How are YOU going to overcome investor biases?
Thanks for reading our blog about investor bias and how to overcome it.
We’ve written other blogs about how to find a financial advisor, what financial advice costs, and the perks of working with a financial advisor. We hope you’ll enjoy reading them, should you so desire.
Need some help curtailing your investor bias when it comes to your portfolio? We are a fiduciary financial advisor in the Philadelphia area, but we work with clients across the country. We provide fee-only, objective advice to our clients on taxes, wealth management, and financial planning. If you would like to discuss a possible relationship, contact us.
Sources
Charles Schwab. November 3, 2021. Fundamentals of behavioral finance: Loss aversion bias. Retrieved from here.
Dalbar, Inc. 2020 QAIB Report for the period ending December 31, 2019. Retrieved from here.