Investor Psychology: How Bias Can Lead to Poor Investment Decisions

investor psychology

To Err is Human, and it’s Impacting Your Portfolio

Investor psychology is what is behind our financial decisions and, sometimes, we have biases that lead us astray. In our drive to create financial security for ourselves, there are times when we are our own worst enemies. That’s because every human being has instinctive behavioral biases that impact our decision-making capabilities. That’s certainly true when it comes to investing and the natural volatility of the stock market, and it means we can easily become susceptible to an emotional rollercoaster that leads to illogical or irrational decisions. One way to combat this, however, is to better understand our own inherent biases.

The Psychology of Investing Biases

When it comes to behavioral finance or investor psychology, there are two overarching types of biases that can impact an investor. The first is cognitive bias, which refers to the tendency to think or act in a particular way or to follow a rule of thumb you’ve adopted over the years. There is also emotional bias, which reveals itself as a tendency to take actions based on gut feelings, rather than facts.

You may consider yourself an unemotional, logical person when it comes to your finances, and it’s true that different people are impacted by inherent biases in different ways – some more than others. However, human nature makes us all a bit fallible in this area, so you may benefit from learning more about the eight types of biases below.

Confirmation Bias

Also known as anchoring, confirmation bias is the most discussed of the behavioral biases. It impacts every part of our lives, including the first impressions we have after meeting a new person. That’s because the human brain tends to selectively filter information, paying more attention to things that support our existing opinions and preconceived notions. If you’re an investor whose thinking is subject to a strong confirmation bias, you’re more likely to fixate on investment information that supports your existing beliefs. To combat this, actively work to seek out information about an investment that contradicts what you currently think about it. Essentially, you can work to overcome confirmation bias by being your own devil’s advocate.

Regret Aversion Bias

This is a fancy way to talk about loss aversion, or our natural inclination to want to avoid feelings of regret after a decision leads to a poor outcome. This plays out with investors when they are influenced by anticipated regret, leading down a path to taking fewer risks in order to lessen the potential for a bad outcome. If you’ve been reluctant to sell off a losing investment, for example, you may need to ask yourself if you’re just practicing avoidance. In a situation like this, it’s best to acknowledge the loss and move forward.


LISTEN TO THE MONEY WISE PODCAST: MARKET PERFORMANCE, EARNINGS SEASON, AND INVESTOR PSYCHOLOGY


Disposition Effect Bias

Are you someone who tends to see the world in black and white? If so, you may want to work on seeing the “gray” a bit better. Investors who are highly impacted by disposition effect bias have the bad habit of labeling an investment as either good or bad. It leads to the harmful habit of hanging on too long to investments that no longer have an upside, and to sell winning investments too soon in an effort to make up for past losses. Letting this bias rule your decisions can lead to increased capital gains taxes and reduced returns.

Hindsight Bias

This dangerous bias is all about perception, and it can really shake an investor’s confidence. In essence, this bias could cause you to believe after the fact that an event was totally predictable and obvious, when in fact you could never have reasonably predicted it.

Familiarity Bias

This bias can be very strong, and it plays out when investors have a preference for well-known or familiar investments. It can overwhelm you to the point that you avoid diversifying your portfolio, even though there are obvious benefits to doing so. If you never get outside your investment comfort zone, you’ll probably suffer a suboptimal portfolio with a greater level of risk.

Self-Attribution Bias

This one can be tricky to admit to because it means you’re overconfident as an investor. Ostensibly, investors who suffer from self-attribution bias attribute successful outcomes to their own actions, but poor outcomes to external factors (or other people). This might be you if you never take responsibility for your own poor investment decisions.

Trend-Chasing Bias

If you’re stuck in a rut of chasing past performance or you believe historical returns predict future investment performance, you’re probably experiencing trend-chasing bias. If you watch a lot of financial entertainment news, you’re likely more susceptible to this one.


LISTEN TO THE MONEY WISE PODCAST: LOWER RETURNS TAKE A HIGH TOLL ON RETIREMENT


Worry

This is both one of the most common of human emotions and a deep bias that can impact your portfolio. It brings up bad memories that color your vision about potential future scenarios. It can lower your level of risk tolerance and lead to an asset allocation strategy that doesn’t truly serve your needs.

What’s an Investor to Do? Hire a Professional!

It’s never easy to admit to your own shortcomings, but we all have them. Being human means, sooner or later, you’re going to be negatively impacted by a behavioral finance mistake. Maybe you already have been, but you’ve avoided facing it head-on. Of course, this leaves you vulnerable to making more misguided investment decisions in the future.

While understanding more about common biases can help you make better decisions, you’ll never be able to erase your biases entirely. That’s why it’s so important to work with financial professionals to build a wealth strategy and manage your portfolio. A good investment advisor understands investor psychology and can help you take the emotion out of your financial decisions.

If you’re in need of a tactical, strategic investment plan, give us a call today. At Davidson Capital Management, we provide disciplined and transparent investment advice so that you can gain the peace of mind that your portfolio is free of behavioral bias and in line with your financial goals. Schedule your portfolio review and analysis with us today and gain confidence in your financial future.