Understanding the psychology behind investment decisions can be as important as understanding the financial market itself. This is because in reality, emotions can often drive investment decisions without even noticing. Investment decisions not based on constructive investment plan but based on emotions such as fear, greed or envy can often cause a costly mistake.
Cognitive and emotional biases are errors in judgement that stem from feelings and intuitions rather than through analytical process. Those biases can impact investment decisions, often leading to sub-optimal outcomes. Cognitive biases are errors in how we process information, thinking and memory, while emotional biases arise from feelings and intuitions leading to a decision-making that is not based on facts.
Common cognitive and emotional biases investors face include the followings:
Conservatism bias: This bias is derived from failing to adequately update beliefs based on new information.
Hindsight bias: This bias causes investors to see past events as predictable.
Anchoring bias: This bias is being fixated on a specific, arbitrary price point such as the price where you bought a stock, rather than looking at the current value or fundamentals.
Confirmation bias: This is a tendency to seek out or remember information that confirms your beliefs while ignoring or downplaying contradictory data and information.
Recency bias: This bias is overemphasizing recent market events or trends over long-term and historical data. This can cause investors to fear of a crash after a dip or overinvest after a rally.
Representative bias: This is a bias whereby you make a judgement based on stereotypes or small samples.
Self-Attribution bias: This stems from taking credit for success while blaming failures on external factors such as bad luck or the market being irrational. This prevents investors learning from their mistakes.
Mental accounting: This bias involves treating money differently depending on intended use or the source, even though all money is interchangeable or fundgible. For example, an investor can be cautious with their salary, investing them in safer bonds. However, when it comes to a large bonus or a tax refund, he or she may use it to buy speculative, risky stocks. However, all money should be considered in a unified portfolio with a single risk strategy.
Overconfidence bias: This bias arises from overestimating one’s knowledge, skills and ability to predict the market moves or picking winning investments. This will cause excessive trading, incurring trading costs, and taking on excessive risk failing to diversify the portfolio adequately.
Loss-aversion bias: This is a tendency to prefer avoiding losses over acquiring gains making incurring losses more painful experience. This can cause investors to hold onto losing stocks for too long to avoid the pain, hoping that they will break even, or to sell winning stocks too early to lock-in the pleasure of gain. This emotional bias can lead to impulsive decisions such as selling during market dips, which often leads to locking in losses harming long-term returns.
Status Quo bias: This is preferring familiar investments such as home-country stocks or failing to make changes to a portfolio even if it is more logical to do so.
Endowment bias: You are placing a higher value on the assets you own. This can lead to holding onto the stocks for sentimental reasons even if it is not good fit for a diversified portfolio.
Regret Aversion: This bias causes investors to refrain from making decisions to avoid potential emotional pain from a wrong decision. It results in inertia, doing nothing when actions are required. This bias can also lead to herd behavior, doing what everyone else is doing. Even if that decision causes a deep loss, you are not alone in your regret.
Self-control bias: Overreaction and impulsivity can cause investors to make hasty trades based on fear and greed often during highly-volatile periods. This bias is resulting from the lack of self-discipline to pursue long-term goals and favoring short-term satisfaction.
Herd Mentality: This is a tendency to follow the actions of a larger group of people regardless of those actions being rational or not. For example, many investors bought assets during the dot-come bubble not because they understood valuations, but simply because many people were getting rich out of it. This tendency inflates bubbles and leads to panic selling during market crashes.
Recognizing these biases is the first step. Next will be creating an investment policy statement. By writing down long-term financial goals, risk tolerance and asset allocation strategy, you can have a rule book to guide you during emotional moments. Automating investments by setting up automatic contributions to the investment accounts can prevent being too emotional as well. Also, diversifying your portfolio designed to withstand the ups and downs of a single investment can reduce emotional biases stemming from a single loser.
Before making an investment decision, ask yourself, “Am I acting on a well-researched plan or am I reacting to fear, greed or news headlines?” By understanding these cognitive and emotional biases, you can start to make more rational and disciplined investment decisions that are well aligned with your long-term financial goals. To overcome these biases, investors need to recognize them first, create a long-term investment plan and stick to it regardless of market fluctuations.