Investopedia defines bias as “an irrational assumption or belief that affects the ability to make a decision based on facts and evidence.” Bias are one of the reasons that being a successful investor can be difficult. Your brain is literally using bad behavior to influence your decisions!
In this post, we’ll introduce you to six biases. Being able to recognize them can help you avoid falling prey to their siren songs.
Behavioral Bias #1: Herd Mentality
Herd mentality is what happens when you see a market movement afoot and you decide to join the stampede. The herd may be hurtling toward what seems like a hot buying opportunity, such as a run on a stock or stock market sector. Or it may be fleeing a widely perceived risk, such as a pandemic, or a country in economic turmoil. Either way, following the herd puts you on a dangerous path toward buying high, selling low, and incurring unnecessary costs along the way.
Behavioral Bias #2: Recency
Even without a herd to spur you on, your long-term plans are at risk when you give recent information greater weight than the long-term evidence warrants. Stocks have historically delivered premium returns over bonds. And yet, whenever stock markets dip downward, we typically see recency at play, as droves of investors sell their stocks to seek “safe harbor.” Vice-versa when bull markets are on a tear, investors pile in, chasing after past returns.
Behavioral Bias #3: Confirmation Bias
Confirmation bias is the tendency to favor evidence that supports our beliefs and gloss over that which refutes it. We’ll notice and watch news that supports our belief structure; we’ll discount that which might prove us wrong. Of all the behavioral biases on this and other lists, confirmation bias may be the greatest risk to long-term investing success.
Behavioral Bias #4: Overconfidence
In “Your Money & Your Brain,” Jason Zweig describes overconfidence in action when he asks: “How else could we ever get up the nerve to ask somebody out on a date, go on a job interview, or compete in a sport?” In these and similar scenarios, a degree of overconfidence can be good. But it often becomes dangerous in investing. Overconfidence tricks us into believing we can consistently beat the market by being smarter or luckier than average. In reality, it’s best to patiently participate in the market’s expected returns, instead of trying to go for broke – literally.
Behavioral Bias #5: Loss Aversion
As a flip side to overconfidence, we also are endowed with an over-sized dose of loss aversion. In fact, academic insights suggest we dislike the thought of losing money about twice as much as we enjoy the prospect of receiving more of it.
One way that loss aversion plays out is when investors prefer to sit in cash or bonds during bear markets, or even when stocks are going up but a correction “feels” overdue. The evidence clearly suggests you are likely to end up with higher long-term returns by at least staying put in the market, if not bulking up on stocks while they’re relatively cheap. But even the potential for future loss can be a more compelling stimulus than the higher likelihood of long-term returns.
Behavioral Bias #6: Sunken Costs
We investors also have a terrible time admitting defeat. When we buy an investment and it sinks lower, we’re reluctant to lose our initial stake. Anchoring, which is another bias, may convince us to avoid selling anything until we can at least recover our sunken cost.
In a data-driven strategy (and life in general), the evidence is strong that this sort of logic leads people to throw good money after bad. In the long run, it’s essentially irrelevant whether an individual holding in your portfolio has gone up or down. By refusing to let go of it once it no longer suits your greater purposes, an otherwise solid investment strategy gets weighed down by emotional choices and debilitating distractions. The better question guiding when to hold and when to sell is whether or not a holding continues to makes sense within your overall portfolio.
So, there you have it. Six behavioral biases to avoid. But be forewarned: Even once you are aware of your behavioral stumbling blocks, it’s still difficult to avoid tripping on them. By definition, your instincts fire off lightning-fast reactions in your brain well before logical thinking kicks in. This is one reason we suggest working with an objective advisor, to help you see and avoid the collisions that your own myopic vision might miss. If we can help you in that mission, please be in touch.