8 Behavioural Biases that Impact Investment Decisions

What if I were to tell you that the mood you are in can have a powerful impact on the financial decisions you make? We’ve all had a footloose and fancy free day where we’ve loosened the purse strings in the name of fun and spent more than we’d planned. I for one won’t be calling in the fun police. Sometimes you just have to live in the moment! My official position on this as a Certified Financial Planner is that small splurges every now and then can be easily enough balanced in the short term.

But what about major financial decisions such as investments that affect us in the medium to long-term? It’s important to be aware that behavioural biases, moods and emotions can corrupt rational thinking about our financial decisions. Think of it as the difference between the right decision and ‘what feels right’. They’re not always the same thing.

Of course, I should acknowledge here that humans aren’t robots! My personal experience as a non-robot has taught me that it isn’t possible to completely separate our emotions from our decisions, financial or otherwise. Fully data-driven cognition is for Artificial Intelligence only.

That said, I believe that insight into human psychology can protect us from our ‘glitches’, and no truer is this then when it comes to financial behaviours. With that in mind, this article will outline the 8 behavioural biases that impact our financial decision making. Being aware of these is not a guarantee of success, but it will help you think twice about how you choose your investments and the management of them.

What is ‘Behavioural Finance’?

From an academic perspective ’Behavioural Finance’ is a developing research field that brings psychology and finance together in a multidisciplinary approach to decision theory. In everyday application the concept of ‘Behavioural Finance’ helps us to recognise the natural biases that lead us to make illogical and often irrational decisions about our investments and finances.

Anchoring or Confirmation Bias is the tendency to hold on to a first impression and then apply it as a subjective reference point for making future judgments. It’s a selective filter that people impose — preferring to confirm the information they already know rather than opening their eyes to new financial insights.

If you’re like me then you hate the feeling of regret. Most people do and will try to avoid it even if it isn’t logical to do so. The regret aversion bias describes the desire to avoid the feeling of regret experienced after making a financial decision with a negative outcome. Being influenced by anticipated regret will causes some investors to take less risk in an attempt to reduce the potential for an unfavourable outcome.

The regret bias also explains an investor’s reluctance to ‘cut their losses’ because selling a loss-making investment means having to admit the fact that they made a poor choice. It seems easier to do nothing since this allows you to defer the feeling of regret. Ultimately, however, this will only increase total loss.

The disposition effect is closely related to regret aversion. It refers to the tendency to sell stocks that have increased in price since purchase (“winners”) too early, and to offload stocks that have fallen in price since purchase (“losers”) too late.

The flip side to “cutting your losses’ is to “let your profits run”. Sticking to both pieces of advice requires discipline but overtime will generate higher returns.

The familiarity bias occurs when investors routinely opt for familiar investments despite the seemingly obvious gains that can be made by diversification. Typically this means displaying a preference for local assets with which an investor is most familiar (‘local bias’). Portfolios affected by familiarity bias are therefore tilted towards domestic securities (home bias), opening an investor up to the risk of ‘putting all your eggs in one basket’.

To overcome the familiarity bias investors should cast a wider net to include international investments. Wider diversification reduces financial risk.

Investors who credit successful financial outcomes to their own actions, but blame bad outcomes on external factors are deemed to exhibit self-attribution bias. This is often done for self-protection or self-enhancement. Be warned — it can develop into overconfidence, which in turn can lead to overtrading and underperformance.

Keeping track of personal mistakes and successes and implementing accountability mechanisms such as peer feedback can help investors to recognise self-attribution bias.

This is probably the strongest trading bias. It refers to the belief that studying historical returns can predict future investment performance. However, detecting investment patterns in the past cannot in themselves validate future financial predictions. The truth is that the market is far more random than most people care to admit.

Mutual funds take advantage of the trend-chasing bias by increasing advertising when past performance is high. But the reality is right under our noses in the disclaimer they carry: “Past performance is not indicative of future results”.

Investors should resist being pulled align with the crowd and focus on their own goals. It might feel like the right thing to do, but this strategy is unlikely to yield long term superior success.

This links to the trend-chasing bias. Representativeness causes investors to label an investment as good or bad depending on its recent performance. Consequently, they buy stocks after prices have gone up in expectation that they will rise further. Conversely, they ignore stocks whose prices have fallen in anticipation that they will continue to decrease in value.

In order to be successful investors need a far stronger analytical framework that should be continuously refined based on results.

Worry is an everyday, ordinary human emotion. It evokes memories of past anxiety and causes visions of possible future financial scenarios that alter an investor’s judgment about how they should manage their personal finances.

Anxiety about an investment increases its perceived risk and therefore lowers the level of risk tolerance among investors.

In order to avoid worry bias investors should match their level of risk tolerance with an appropriate asset allocation strategy. As a quick test, if you cannot sleep because of apprehension about your investments, it might be better to have a more conservative and hence less risky investment portfolio.

Being aware of these 8 behavioural biases helps us to reduce the negative impact that human psychology can play on our investment decisions.

Can you think of any other biases I have missed, or maybe you have a question relating to this topic?

Related posts:

It seems impossible to remember the days before Netflix turned “bingeing” into a positive word. Before 2008, “bingeing” was associated with trips to Baskin Robbins during bouts with low self-esteem…

2020 caught us all by surprise, to say the least. Maybe some astrologers knew what was coming, but most of us laypeople were pretty much clueless. Interestingly, I recently discovered two artists who…

The latest trend emerging in the industry these days is of the artificial flower arrangement that brings a new life to your home and surroundings. You can easily decorate the interior and exteriors…