Humans like to think of themselves as rational, and economists have historically modeled the markets with the assumption that people will act rationally. Instead, investors tend to react to market movements with a range of biases, from overconfidence to costly loss-aversion bias.
Behavioral finance, pioneered by Daniel Kahneman and Amos Tversky, challenged the steadfast belief that markets are driven by classical economic theory.
This past year was marked with pronounced emotional moments where investors went from feeling like it was 1929 in March 2020, to feeling like they were experiencing the 1999 market euphoria in January 2021.
One of the most important things you can do as an investor is to understand ingrained psychological biases. Being aware of these biases can help prevent poor decision-making during emotionally charged moments. Here are three biases to be aware of and how to combat them:
- Overconfidence bias
- Loss aversion
- Confirmation bias
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As painful as it is to admit, people have an inherent bias toward believing that their skill and ability is greater than it actually is. For example, an investor who bought stocks in 2020 probably saw them perform well and likely attributed the investment success to superior stock-picking ability rather than luck.
Overconfidence bias leads investors to underestimate risks because they create a narrative based on what actually happened rather than what could have happened. This natural tendency for investors can lead to poorly diversified portfolios and more frequent trading.
To combat this bias, maintain broad diversification and expand your time horizon. Broad diversification is an admission that you do not know if you are right, and having a long-term time horizon allows the magic of compounding to work in your favor.
Loss Aversion
This is a big contributor to why investors make the mistake of selling investments low and buying high. It is the tendency to experience financial losses twice as acutely as equivalent financial gains.
Think back to late-March 2020 and looking at your portfolio. The S&P 500 was down by double digits for the month alone. The world was in chaos, and people were panicking. The markets promptly rallied more than 20% by early April. However, the psychological discomfort from being down felt much worse than the feeling on July 30, 2020, when markets had rallied.
The propensity to feel losses more than gains puts investors at a disadvantage because they are most predisposed to make a mistake at the point of maximum emotional pain. Combating this bias is extremely difficult.
One way to deal with this bias is to always have a certain amount of money in cash or money market accounts to help you sleep at night. The amount will vary depending on your circumstances and risk tolerance. But having that buffer will help prevent you from selling out at the worst possible time.
Confirmation Bias
Perhaps one of the more subtle biases that affect professionals and amateurs alike is confirmation bias. Investors build opinions about the way investing works, how to value a company or what will drive the next financial bubble.
As conclusions are reached, investors are naturally inclined to seek out information that confirms their previous conclusions and to discard information that refutes or challenges their conclusions. The cognitive strain from constantly factoring in new information and updating prior beliefs leads people to ignore or place little emphasis on conflicting information.
Many of the greatest investors will deliberately seek out information from a range of sources, discussing their thoughts with a diverse and independent group of people. Warren Buffett routinely invites a Berkshire Hathaway (ticker: BRK.B, BRK.A) bear to the annual meeting to bring a diverse viewpoint that challenges the herd mentality.
People not aware of confirmation bias may make the mistake of falling in love with stocks they own or missing emerging opportunities because "things were never done that way."
Investing and building wealth is straightforward, but it is not easy. People use their intuition to make decisions about investing and money more generally. The problem with this approach is that intuition can lead to inaccurate conclusions. The psychological biases discussed here represent only some of the biases that are affecting our daily decision-making.
Takeaway
There is no way to eliminate these biases because they are human nature. Investors can, however, be aware that they exist and slow down their thinking when making important financial decisions.
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