Financial markets are often viewed as rational systems where participants make logical decisions based on available information. However, psychological research has consistently shown that human behavior in financial markets is far from rational. In fact, a Morningstar study found that 98% of their sample respondents exhibited at least one investor bias1. In this article, we’ll explore some of the most significant behavioral biases that impact our financial decisions and how to recognize and overcome them.
Loss (or Regret) Aversion: Why Losses Hurt More Than Gains Feel Good
When it comes to finances, losing money triggers stronger emotional responses than gaining the same amount – for instance, losing $100 causes more distress than the joy of gaining $100 brings. According to Nobel Prize-winning psychologist Daniel Kahneman, people feel the pain of a loss about 2.5 times more intensely than the pleasure of an equivalent gain.2
What are some ways that loss aversion can impact financial decisions?
- Holding on to losing investments too long, hoping to break even
- Selling high-performing investments too early to “lock in” gains
- Avoiding necessary risks, even when the potential returns justify them
Confirmation Bias: Seeking What We Want to Believe
Confirmation bias occurs when people tend to seek out and accept information that supports their pre-existing views while often ignoring or rejecting evidence that challenges them. With social media and 24/7 news readily at our fingertips, it’s easy to make a conscious decision to follow those whose thoughts reinforce our own existing beliefs. This bias appears in various aspects of our lives, such as our political views and our parenting choices.
What are some ways that confirmation bias can impact financial decisions?
- Reading only positive news about investments you own
- Dismissing valid criticism of your investment strategies
- Following analysts who share your market outlook
Anchoring: Getting Stuck on Numbers
Anchoring is a cognitive bias where people overly rely on initial reference points when making decisions. In investing, this often means fixating on a particular number – like a previous purchase price, market peak, or round milestone – rather than evaluating current market conditions and fundamentals.
What are some ways that anchoring can impact financial decisions?
- Refusing to buy stocks above a previous purchase price, even when company fundamentals justify the higher valuation
- Trading decisions influenced by arbitrary round numbers (like the S&P 500 hitting 6,000)
- Using past market highs or lows as mental reference points that distort the evaluation of current prices
- Projecting future returns based primarily on historical performance
- Pegging to initial analyst price targets which can disproportionately influence investment decisions, even as conditions change
Herd Mentality: Following the Crowd
Herd mentality in financial behavior refers to the tendency of investors to follow and imitate what others are doing rather than relying on their own analysis and judgment. It’s the financial equivalent of “following the crowd” and can be seen in various market phenomena. An article by Tim Vipond of the Corporate Finance Institute discusses how one can feel actual emotional and physical pain when making a decision that goes against the crowd.3
What are some ways that herd mentality can impact financial decisions?
- Buying popular stocks without proper research
- Panic selling during market downturns
- FOMO (Fear of Missing Out) in bull markets
- Avoiding contrarian investment opportunities
Overconfidence: The Illusion of Control
Overconfidence bias is the tendency to overestimate one’s skills, knowledge, and judgment, often leading to misguided decisions. This cognitive bias manifests in various aspects of life, such as driving and finishing certain tasks, where individuals believe they are more competent than they actually are. In the realm of finance, overconfidence can be particularly dangerous, as it often stems from past successes that reinforce the illusion of control.
What are some ways that overconfidence can impact financial decisions?
- Excessive trading
- Inadequate diversification
- Underestimating risks
- Ignoring professional advice
Home Bias: The tendency to Favor Domestic Over Foreign Investments
Home bias can cause investors to put too much money into their home country’s stock market, which can increase risk and limit diversification benefits. Investors may feel more comfortable investing in companies they know, and foreign investments may be outside their comfort zone.
What are some of the ways that home bias can impact financial decisions?
- Increasing the risk of an investor’s portfolio
- Limiting the diversification benefits of an investor’s portfolio
- Causing an investor to overlook a potential rewarding investment opportunity
- Reducing an investor’s potential long-term returns
How to Combat Behavioral Biases
Recognizing and overcoming behavioral biases requires self-awareness and discipline. These biases are not only shaped by personal experiences but can also be influenced by our upbringing, cultural norms, and early exposure to financial values. For example, if we grew up in a household where money was a source of stress or scarcity, we may develop a fear of loss or an overzealous desire to accumulate wealth. While we can’t completely eliminate these cognitive distortions, we can take proactive steps to reduce their impact on our financial decisions:
- Acknowledge Their Existence: Recognize that no one is immune to behavioral biases. Understanding that they exist is the first step to managing them.
- Implement a Systematic Approach: Develop and stick to a written financial and investment plan. Let this serve as your roadmap.
- Seek Outside Perspectives:
- Consult with a financial advisor.
- Listen to opposing viewpoints.
- Consider multiple data sources. Every quarter, read one bullish analyst report and one bearish analyst report.
- Challenge your own assumptions – or have an investing friend play “devil’s advocate.”
- Keep a Trading Journal: Document your investment decisions and the reasoning behind them. This helps identify patterns in your behavior and areas for improvement.
Successful investing isn’t just about analyzing markets and selecting investment vehicles – it’s also about understanding and managing our own behavior. By implementing structured strategies, such as setting clear investment goals, seeking diverse perspectives, and maintaining a disciplined approach, investors can avoid impulsive mistakes driven by emotions. The key is to create safeguards that encourage rational decision-making, even in volatile or uncertain market conditions.
¹ Das, Sarwari. “Who’s Influenced by Behavioral Biases? Everyone” https://www.morningstar.com/stocks/whos-influenced-by-behavioral-biases-everyone#who-exhibits-behavioral-biases. 5/25/2021
² Kahneman, D. (2011). Thinking, Fast and Slow. Farrar, Straus, and Giroux.
³ Vipond, Tim. “Herd Mentality” https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/herd-mentality-bias/. n/d