I consider myself a quite rational and normal human being. I make decisions based on facts and rarely let my feelings guide me – especially not when it comes to money.
However, when it comes to investing, I have experienced many behavioral biases that impact my investments.
Even though I am aware of these biases and have taken several behavioral finance courses (and even done experiments on them), I still experience these irrational feelings. I keep on getting the same feelings even though I know that they are irrational.
If you are investing in anything from stocks to bonds to startups, you should be aware of these behavioral biases as they can negatively influence your investment choices.
Five common investment biases
There’s quite a few behavioral biases (or cognitive biases) that can influence investments, but they also influence many other things in our daily life.
If you are interested in a complete list of behavioral biases that can impact investments, check out Wikipedia’s list of cognitive biases – although not all apply to investing.
Below I have chosen my “favorite” biases because they are the ones I am most prone to myself.
1. Prospect Theory
An acknowledged theory within behavioral finance is Prospect Theory.
The theory states that you feel investment losses more painful than investment gains feel good.
This might sound a bit weird, but I have recently tried it myself. For the past 6 months, I have lost money on my stock index investments.
I promise you, it is not a good feeling to see red numbers on your investments (bye bye early retirement!). Recently, they have slowly started climbing again, but I does not feel as good as the losses felt bad. I somehow just assume that they should grow steadily.
Be aware of these emotions when investing. For example, painful losses can lead to irrational decisions of selling at the wrong time.
2. Self-attribution bias
Self-attribution bias is in line with the concept of overconfidence.
When you experience self-attribution, the typical reaction is to invest more in investments that are going well.
I know the feeling from when I re-balance my portfolio to investment share targets.
Naturally, some index funds have significantly higher returns than others.
Therefore, it is really hard to look at historically greater returns and put money in an index fund that has historically worse returns. This is when you have to remember that historical returns do not say anything at all about future returns.
3. Confirmation bias
Confirmation bias is an investment bias I am very much prone to.
The concept of confirmation bias is to seek out one-sided information to confirm your own views.
I am currently investing in cryptocurrencies and I am following a range of cryptocurrency groups and websites. If you are following cryptocurrency investments, you know how quickly the landscape changes and how much speculation there is in it.
Being a cryptocurrency investor and following all of these news, I have discovered that it makes me feel good when people comment on posts confirming my views and past investment decisions. However, when people comment negatively on investment choices I have made, I (unconsciously) try to discard their views in various ways.
My last cryptocurrency investment was driven by a number of people positively commenting on the price of a coin that I had been looking at for a while. Guess what? After investing, its value dropped with 50% a few days later.
I guess it is about time to unfollow those cryptocurrency groups and websites – and check back on the balance of my investments in five years from now. It might be zero, it might be unchanged and it might be positive. No reason to worry until then.
4. Regret aversion bias
Regret aversion bias is an investment bias that makes people take less risk to minimize the chance of making losses.
The bias typically follows a bad investment and it negatively impacts your returns because you are too focused on lowering your risk.
Now, it is important to mention that having a low-risk investment strategy is not necessarily bad, however, it is bad if you have it just for the sake of minimizing the chances of experiencing losses.
In my cryptocurrency example above, I actually think that my 50% loss on a single coin in a few days has made me more concerned about taking on risk. In the case of cryptocurrencies, it might be a good decision as no one knows what will happen and things are highly volatile.
I have actually decided not to invest a single cent more in cryptocurrencies going forward – and I think regret aversion has something to do with it.
5. Disposition effect bias
The disposition effect bias is one of my favorite biases.
The concept of the disposition effect predicts that an investor will sell winning investments too quickly and sell losing investments too late.
The feeling you experience once you have gained on your investments makes you want to secure the returns before the price falls again (“I better take the money while I still can”). However, behavioral finance experiments have shown that people tend to sell too quickly and as a consequence do not realize the full upside of their investments.
On the other side, the feeling you have once you have lost on your investments is a hope that they will climb back again (“If I just hold for a little while longer, things will become better”). Again, behavioral finance experiments have shown that people tend to hold on too long to losing investments in the hope that they will rise from the ashes. Therefore, they miss out on even better investments at the same time.
I personally have had a tendency to sell too early and too late in my 3-month cryptocurrency trading career – a career which has already officially ended. But let’s be honest, if you look at this Bitcoin price chart, how can you not be prone to the disposition effect bias (and all of the other biases) with things growing/dropping with double digits every day:
You should learn from my mistakes and try to avoid the disposition effect.
How to avoid the behavioral investment biases
Now, the good thing is that I will rarely have to deal with these investment biases going forward. The even better thing is that you can also avoid behavioral investment biases.
I am following a strict minimal effort investment strategy. The allocation of my portfolio is clear. I invest and hold those investments for the long term. I invest in good and bad times to minimize the volatility.
Therefore, I rarely have to make any decisions that can be influenced by investment biases. By following a strict investment strategy, you minimize the chances of behaving irrationally.
If you are speculating and investing in the short term, you will definitely have to deal with these biases more often – and you should be very aware of how they influence your decisions.
If you want to learn more about how irrational human beings really are (and not only when it comes to investing), you should definitely check out the book Predictably Irrational by Dan Ariely. It is an interesting and fun read!
Your turn: Have you ever experienced any of these behavioral investment biases? How do you deal with them?