Investor Psychology: How Investment Biases Affect Decision Making

Key takeaways

• Traditional economic theory assumes rational decision making, with an individual always looking to maximize their utility.

• Behavioral finance, which was comprehensively discussed for the first time in “Thinking Fast and Slow” – a book by two Israeli professors – theorizes that psychological biases play a far more significant role in economic and financial decisions than previously believed.

• Investment biases can lead to suboptimal decisions, especially on trading platforms where a retail investor has the ability to make decisions without having access to key information.

Investment biases, a recent discovery, are almost universally recognized as affecting decision making. 

While traditional finance assumed the investor to be completely rational, and able to fully harness the power of data. Behavioral finance researched how investor’s psychology plays a prominent role in their decision-making processes. Behavioral finance identified several biases affecting an investor’s decisions – such as fear, overconfidence, unfounded instinct, the herd mentality, or erroneous perceptions of past experiences. 

Below are some of the most common behavioral biases investors would do well to recognize and counter. 

Regret avoidance

Regret avoidance refers to the bias that pushes investors to hold on to a losing position for too long. The psychological element here is the human tendency to refuse to admit having taken the wrong decision.    

Loss aversion

Kahnemann and Tversky – the authors of “Thinking fast and slow” – proved in a class experiment that investor satisfaction changes depending on what amount of gains or losses they are dealing with. As losses increase, they noticed, investors tend to be more reluctant to exit the position as they do not want to realize the loss. The same bias can lead to selling winning positions too early, for the excitement of booking a gain.  

Mental accounting

Mental accounting – a bias mostly researched by economist Richard Thaler – is the human tendency to classify funds in a different way. In finance, it manifests itself in a piecemeal approach to portfolio management and asset allocation, with individuals looking at their investments separately rather than holistically. 

A typical mistake is an individual holding a high-yield savings account while keeping credit card debt. 

Anchoring bias

Anchoring is the tendency to rely on the first piece of information, while disregarding later updates. It can potentially push individuals to fail to update an investment thesis when new elements appear. 

Framing 

People often vary their response to a situation in accordance with the context in which the situation was initially presented. For example, in an instance in which individuals are presented with the opportunity to participate in a fund, having the choice between opting out or opting in can have a strong effect on the degree of participation achieved. 

Over and under reacting 

This bias can make people’s investment decisions reliant upon current events, rather than factoring historical data into their decision-making. In financial markets, this can manifest through good news about a company tends to make its stock price rise significantly, while bad news can erase gains seemingly overnight. 

Overconfidence 

When it comes to finance, too many investors believe they have the ability to see trends coming and get in or out of an investment at just the right moment. This overconfidence can manifest itself in excessive trading, which, in turn, triggers costs that could otherwise have been avoided. 

Self-attribution 

When an investment goes well, those who are subject to engaging in self-attribution bias tell themselves their talent, foresight, or some other innate ability led to achieving the gain. Failures, on the other hand, are attributed to bad luck or some other external stimulus. In other words, their success is dispositional, while their failures are situational. 

Self-attribution bias can goad investors into engaging in unnecessarily risky trades, which can inflate the volatility of their investments. 

Disposition effect

The disposition effect occurs when investors maintain a position in a losing investment for far too long and sell out of a winning one much too soon. This action is also known as the asymmetric value function, which refers to the fact that the pain of a loss outweighs the joy of a gain in the mind of an affected investor.

Familiarity bias

While a fundamental piece of advice when it comes to investing is to buy into things you know, that advice can be taken too literally. Some people will only invest in stocks with which they have some familiarity, which can lead to insufficient diversification. 

Staying with the tried and true may bring a sense of comfort, but it also inhibits the ability to profit from the new and unfamiliar. 

This is often found in portfolios of people who work for companies whose stocks are publicly traded. A tragic example was made evident when Enron went under back in 2001. The company’s stock comprised 62% of the holdings in its employee’s 401(k) portfolios. The value of those retirement investments sank, right along with the company. 

Gambler’s fallacy 

The gambler’s fallacy, also known as the Monte Carlo fallacy, occurs when an individual erroneously believes that a certain random event is less likely or more likely to happen based on the outcome of a previous event or series of events. In a series of coin tosses, for instance, in every new toss the odds of head or tail coming out are always 50%, no matter what happened in the previous rounds. 

Representativeness 

Representativeness is bias that pushes investors to believe that a company that has performed well in the past will continue to do so into the future, regardless of the changes in factual circumstances. 

Recency 

Recency is a heuristic that affects investors who base their willingness to invest on recent market trends, at times buying at market peak or selling at its trough. 

Countering These Biases

We have discussed several behavioral biases that can affect investors’ decision-making. Unfortunately, these biases can lead to mistakes such as holding onto losing positions for too long, selling winning positions too early, being overly confident in one’s abilities, and making decisions based on recent events rather than historical data.

Just to reiterate: heuristics are increasingly recognized as influencing investor behavior, regardless of the level of sophistication. To counter that, most investment professionals attempt to construct elaborated investment theses based on tangible data, but even that sometimes fails to completely shield from biases. Retail investors can be particularly at risk as they have recently gained access to an increasing number of public market products without the intermediation of investment professionals. 

Here are a number of tips to consider to deal with the above biases:

As an investor, you want to understand that your decision making may be influenced by biases, such as fear or overconfidence. By recognizing these biases, you take steps to counteract them.

Developing investment strategies based on tangible data, such as company financials and market trends, helps to ensure that investment decisions are rational and not based on emotions.

We also believe that investors should have a long-term focus when investing. Short-term fluctuations in the market can be unpredictable, but a long-term perspective can help investors weather these ups and downs.

Emotions, such as fear or excitement, can lead investors to make irrational decisions. By not making decisions based on emotions, investors can make more rational investment choices.

Diversification is a key strategy for mitigating risk in investing. By spreading investments across different types of assets (including alternatives), investors can reduce the impact of any single investment on the overall portfolio.

Seeking guidance from investment professionals is another way to counter the biases. Financial advisors or portfolio managers can provide expertise and guidance on investment strategies.

Continuous education on investment strategies and biases is also helpful in making informed decisions and avoiding common investment pitfalls.

Keeping a record of your investment decisions, evaluating and adjusting them regularly is another useful tip. This can help you track your progress and identify areas for improvement.

While investments in alternatives have long been seen as risky, a strong selection and due diligence process can help mitigate underwriting risk. Since the process is carried out by investment professionals, the risk of falling prey to heuristics can also be reduced. 

Learn more about the ways Willow Wealth can help diversify and grow your portfolio.