Imagine you are at a supermarket, ready to pay for your groceries and go. You evaluate the available checkout counters and quickly decide on one of them. Multiple factors may have motivated your decision: the length of the line, the cashier’s attitude, or the number of groceries the customer in front of you is buying. Our minds are constantly calculating, even if we are not cognizant of it. Decision-making gets more complicated when you add another variable: biases.

Now apply this scenario to the investing world: You are evaluating different asset options for your portfolio. There are numerous elements to consider – price, historical performance, intrinsic value, information about the company and its financial position (like its balance sheet or size), and time horizon. All of these and more may factor into your final decision.

Behavioral finance is the study of the psychology that influences investor decisions. What information do you choose to help guide your investments? Do you have rules in place to hedge against feelings or unfounded beliefs? Whether we are aware of it or not, we all have biases that affect our decision-making, and becoming aware of them can help us to make better decisions.

Even Warren Buffett, one of the most well-known and accomplished investors of all time, is aware of his investment predispositions. He knows he needs people to present different perspectives to him; otherwise, he becomes locked in his own worldview. That’s why he has invited vocal critics to Berkshire Hathaway’s annual meetings: so he can check himself against his own biases.

How biases can affect decision-making

Traditional finance tends to assume that investors are rational. However, this premise is flawed because humans do not operate robotically – we are all subject to bounded rationality. We try to make satisfactory choices, but not necessarily the most optimal ones. Most of the time, we operate within a limited framework. These limits include cognitive ability, time constraints, and imperfect information or context.

In complex scenarios like investing, there tends to be a proliferation of biases, which function like mental shortcuts. Investors must filter through myriad information to shoulder the burden of numerous decisions tied directly to money. Biases help investors reach satisfactory decisions faster, and they may ease the burden of thinking through a range of convoluted investment scenarios.

But there can be a substantial cost to relying on inherent biases.

You may be wondering: Is it really so complex? It’s just decision-making, after all. As in the supermarket example, we make decisions all the time, and it can happen in seconds. But the answer is a resounding “Yes.”

The Wall Street Cheat Sheet created a graph illustrating the market cycle, which covers the range of emotions experienced by investors. The wave pattern illustrated by the graph below shows how layers of complexity can build when you take the breadth of emotions and factor in buy/sell calls, diversification options, and other strategy components.

Psychology of a Market Cycle: The Feelings Appearing As The Market Fluctuates
Source: New Trader U

An investor’s own proclivities may be easier to recognize and combat when it is smooth sailing and the markets are up. But when there is a dip in the wave cycle, panic suddenly sets in, anxiety clouds our judgment, and we become far more susceptible to cognitive biases.

“The investor’s chief problem — and even his worst enemy — is likely to be himself.” — Benjamin Graham, economist and author of The Intelligent Investor

The most common biases impacting investor decisions

It is not just emotions that cause biases and affect our investment decision-making. Three other catalysts are at play: social influence, self-deception, and a concept called heuristic simplification. The latter category refers to information processing errors or misinterpreting data. Together with emotions, these are the four primary buckets from which biases stem.

As with any habit or discipline, it is crucial to understand areas of weakness in order to overcome them. According to a survey by the CFA Institute (generated from the responses of 724 practitioners across the world), the five most common biases impacting investor decisions are herding, confirmation, overconfidence, availability, and loss aversion. We have put them together with two other biases (anchoring and regret avoidance), which we believe are equally impactful on investor decisions.

Behavioral biases and the degrees of their influence on investment decision-making
Source: CFA Institute

1. Herd behavior

Herd mentality is when investors follow a trend, rather than basing their decision on historical or financial data. We have all been in situations like this in other contexts, such as concerts or amusement parks, where we followed the crowd because we do not know the way, and we assume they are going in the direction of where we want to end up. Yet when we picture this in a financial setting, it results in a misguided sense of trust in the flow of the majority. Herd behavior can also result from factors such as time constraints, groupthink, or peer pressure. Following a general trend rather than performing your own due diligence is significantly risky, as you could end up buying an asset at a high price, only to see its value decrease.

How to avoid this

There are both private and public external influences that contribute to herd behavior. Private influences include friends and family, while public influences can be the media, social media influencers, or general market sentiment. It does not matter how enthusiastic or sincere any of these influences are if they are misguided. If you see a sudden upward trajectory in price trends, it is all the more reason to research the intrinsic value of that pick. Trends ride momentum, so it is important to develop an efficient system to verify the value of an asset pick, thereby testing the groundlessness of market swings.

Warren Buffett’s approach is to “be fearful when others are greedy, and greedy when others are fearful.” On the other hand, it is hard not to seek profits in an industry in which everyone seems to be making money.

2. Anchoring

Anchoring is the tendency to rely on the first piece of information received and disregard any later information or updates. For example, if your friend asks you where the Credit Suisse stock will be in six months’ time, you would look at what their value is today and make an assumption using present data as a benchmark. After five months, your friend repeats the question. At that point, you are subject to anchoring if you do not look at new data about what has happened since that first conversation. Anchoring means making a decision by relying on outdated information.

Investors rely more heavily on anchors in complex markets, like currencies, where it is exceptionally perplexing to determine value. An anchoring bias makes it easier to keep pace, but it is a dangerous gamble. The proliferation of anchors is perilous because these do not necessarily reflect the intrinsic value of the investment. It is vital, therefore, to look at the most current and relevant data because a lot can change on a daily basis.

How to avoid this

Take a methodical approach. In the example above, rather than estimating an asset’s value in six months’ time based on today’s data, use a financial formula like the Discounted Cash Flow (DCF) analysis to model the asset’s potential future value. This will be far more accurate than an offhand approximation. Don’t worry if you have little to no experience working with formulas. Financial tools exist for most scenarios, as well as free online resources like calculators and step-by-step articles. These simple tools can help you to maximize the value of the data at hand.

3. Overconfidence

Some investors are overconfident in their abilities. They believe they, and no one else, can spot trends and successfully navigate investment scenarios. This mindset becomes detrimental when these investors try to time the market. More often than not, they face a painful reality check. The old idiom “the market always wins” holds true; anywhere from 85-96% of day trades don’t make a return, and even professional investors with access to the best tools and resources make egregious mistakes.

How to avoid this

Besides incorporating a healthy dose of humility into your approach to investing, you should purposefully seek out voices of dissent or reasons why it's not working. Remember the Warren Buffett example? He found someone who criticized Berkshire Hathaway and invited this person to his annual meeting to share their views. As a result, Buffett’s decision-making became more informed and not limited by his own personal biases. Talk to professionals, solicit advice, and stick to passive investing instead of trying to time the market — these are important ways to avoid an overconfidence bias.

4. Loss aversion

A typical bias investors hold is acting to avoid losses over seeking gains. Loss aversion and overconfidence are not mutually exclusive, so be wary of both, as they can coexist simultaneously. The former involves taking on too little risk. It might look like not selling when the timing is right or investing in too many low-return, low-risk assets. The issue with this bias is that it may cause investors to miss out on lucrative opportunities.

How to avoid this

The best way to avoid loss aversion is by building a diversified portfolio. Diversification helps to reduce risk in order to minimize losses, so that your portfolio is balanced with investments that can build significant wealth over longer time horizons. In short, diversification gives you the best of both worlds.

5. Regret avoidance

Sometimes investors are biased to hold onto a losing position for too long in the hopes that it will improve in time. However, this rigid adherence to a buy-and-hold strategy can impact the performance of their portfolio. It is critical not to panic during a price dip, but it is equally important (if not more so) to recognize a losing scenario and know when to sell. People do not want to admit when they have made the wrong decision, and this can become a severe mental block.

How to avoid this

Like all of the biases discussed in this article, regret avoidance is very much a psychological battle. No one wants to feel regret, and it can be a major blow to the ego, so the lengths we take to avoid it can sometimes take a turn for the absurd. The way to counter this is with concrete rules for investing so that you are not making decisions on a whim. For example, if an asset loses a certain percentage of its value – sell. Do not make exceptions. Exit the position and deal with the regret at an early stage. Of course, if you are uncertain, return to basics and review the company’s data to verify your parameters.

On the other hand, if the value rises above a certain threshold, utilize trailing stops. These protect gains if the price moves in a favorable direction. Close by a specified percentage or amount if it changes for the worse. These types of tools and automation help remove emotions from the equation.

6. Confirmation bias

People tend to filter information to suit a preconceived notion they might have. They pay close attention to data that validates their beliefs and disregard the rest. In investing, this type of bias can take several forms. For instance, it can look like operating based on current events because it fits a narrative instead of factoring in historical data (also known as “recency bias”). Or it can look like ignoring due diligence and picking assets based on their market price, rather than intrinsic value, because an investor feels a certain affinity for a particular asset. Siloed decision-making or a piecemeal approach are major issues because they ignore context, and the consequence is decision-making based on fallacies that can lead to losses.

How to avoid this

In all situations, seek to understand the asset before you make any decisions. Look for reasons to disprove your ideas rather than confirm them (much like with an overconfidence bias). This is the best way to avoid falling prey to confirmation bias.

Conclusion

We are all human. We are all susceptible to biases and will make mistakes – that is the only guarantee. You can help to reduce risk by being aware of potential shortfalls and understanding both yourself and the assets you are investing in. Implement as many tools and rules as possible to remove biases from the equation so that your decision is based on actual data.

If you make the wrong move, do not linger on missteps. These happen. The correct path seems obvious in retrospect, but rarely is it evident at the moment. Indeed, the best way to hedge against biases affecting your decision-making is, firstly, to become aware of them and, secondly, to put in place plans to mitigate the associated risk. Your portfolio will perform better for it.

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