Common Behavioral Biases Related to Investing
Know the biases to improve your decision making.
In investing, one's behavioral tendencies often dictate the degree to which they are successful. Knowing the behavioral biases that are common amongst investors is a great first step in improving your investment decision making. As noted in the famed investment book "The Money Game", "If you don't know who you are, the market is an expensive place to find out." Being cognizant of the biases mentioned below can help you avoid behaviorally driven mistakes with costly long-term consequences.
#1 - Loss Aversion: Identified by two psychologists, Amos Tversky and Daniel Kahneman, loss aversion is the tendency of humans to place more emotional weight on a loss than on a gain of equal amount. That is, losing X amount of money feels worse than gaining X amount of money feels good. As such, investors may opt for investments with a lower chance of loss, despite lower long-term expected returns, and ultimately end up with a sub-optimal portfolio. Additionally, investors often sell winning investments too early in order to capture a gain and hold losing investments too long to avoid taking a loss.
#2 - Regret Aversion: The fear of making the wrong choice can often lead investors to inaction and negative consequences. Regret aversion may lead investors to be unnecessarily risk-averse or unnecessarily risk-seeking. For example, investors may be reluctant to rebalance out of riskier investments like stocks for fear that, if they do, they will miss out on further gains. This example could lead an investor to take on more risk than they are truly comfortable with and/or more risk than their individual circumstances warrant.
#3 - Endowment Effect: Investors value something more if they already own it than if they were given the chance to acquire it. For instance, an individual that inherits a large amount of stock may be reluctant to sell even if they would not buy the stock if given the option. Investors may become emotionally attached to a stock or an investment that they own and make sub-optimal portfolio allocation decisions as a result.
#4 - Confirmation Bias: Investors tend to look for information that supports their investment thesis and ignore information that contradicts it. The key here is to make a concerted effort to consider the other side of the argument.
#5 - Illusion of Control: Investors often overestimate their ability to control outcomes and attribute successful investments to skill while discrediting poor investments as the result of bad luck. Investment outcomes are dependent on both process and luck and this should be ingrained in every investor's mind.
#6 - Gambler's Fallacy: This bias relates to the belief that a recent trend is bound to reverse. It hinges on the idea of mean reversion, even if future probabilities have little or no dependency on past events. For instance, if a coin is flipped five times in a row and lands on heads all five times, individuals will be more likely to call tails for the sixth flip even though the probability of each flip is 50/50 and each flip is independent of prior events.
#7 - Recency Bias: Individuals place more importance on more recent events. When stocks fall by a large percentage, individuals may be reluctant to buy more because of the recent downward move despite the fact that historical evidence may show that high returns from that low point are now even more probable.
#8 - Anchoring Bias: Individuals place too much importance on an initial piece of information. In investing, this initial piece of information is often the price of the investment. Investors can be reluctant to buy an investment after it has gone up in price by a lot simply because they first evaluated the investment at a much lower price.
#9 - Survivorship Bias: Individuals may develop overly optimistic expectations as a result of focusing on the successful examples and ignoring the examples of failure. One of my favorite examples of survivorship bias comes from WWII. When U.S. aircraft came back from battle and were analyzed for where bullet holes and shrapnel hit in order to decide where to put more armor, there were spots where it seemed that the planes were rarely hit. At first thought, one might think that these areas were less vulnerable but, in reality, it was because when you did get hit there, you didn't come back. In this example, the accounting for survivorship bias by statistician Abraham Wald was crucial for analyzing the defenses of U.S. military planes. Within investing, survivorship bias is often apparent when analyzing the historical percentage of outperforming funds. The percentage of funds that have outperformed within a category over longer periods of time is often inflated because those that have underperformed and subsequently failed or closed down may be excluded.
#10 - Framing Bias: Individuals often make different decisions based on how information is presented to them. In investing, the way in which an investment is presented often impacts an investor's decision making. A focus on the facts themselves and not on how they are presented can improve decision making.
Investing involves risk and risk taking is inherently behavioral. Knowing the common behavioral biases and assessing your own decision making and thought processes with these biases in mind can improve your long-term investment results.