I consider myself to be normal, I’m not more or less rational than the average human being. I make my decisions based on facts – especially when it comes to money.
Or so I like to tell myself.
I have my bachelor’s in business economics and my master’s in Corporate Finance, so I am fully aware of all behavioral biases – when it comes to spending, investing, or earning money.
The fact that I’m fully aware of behavioral investment biases, does not mean that I’m not subject to them.
In fact, I’ve experienced many behavioral biases when it comes to investing.
I am aware of the behavioral investment biases, I know I’m experiencing irrational feelings, but still I’m getting the feeling. They don’t go away. I have even acted on them without knowing that I was subject to them.
Why? Because I was thinking that I knew what the biases were, so I couldn’t possibly be subject to them? Right?
Yeah, that’s not how life works. That you know something doesn’t mean you will act on it.
When you know you should bring lunch to work, you will still not do it.
When you know you should bike to work, you’re still driving.
You know you need to start investing, but you will still be too afraid of the stock market.
In order to be a successful long-term investor, it’s important to be aware of behavioral biases that can lead to poor decisions and/or investment mistakes.
I will list some of the cognitive biases that I have experienced, so you don’t need to make the same mistakes as I did.
Understanding your behavioral biases in investing can lead to lower risk and improving returns. Don’t we all want that?
Common Behavioral Biases In Investing
There are many behavioral or cognitive biases that can influence the way you invest or the way you make decisions in general. Here is a complete list of all biases, which are not all applicable to investing.
1. Confirmation Bias
This is one of the behavioral biases we’re all very much prone to. The concept of confirmation bias highlights the human tendency of seeking out information that confirms our current view.
We’re only looking at one-sided information that is constantly confirming what we’re already thinking.
One danger of confirmation bias is that you can get overconfident with your decision.
You keep seeing your decision confirmed over and over, which can make you think you’re opinion is the ‘right’ one and nothing will go wrong.
At this time last year, I was investing in cryptocurrencies. While I’m not actively investing in it now, I still am invested. There are some cryptocurrency trading groups and my roommates are trading cryptocurrencies as well – going on and on about how great cryptos are.
My last cryptocurrency investment was done only because I was doing research on a coin that I was following for some time, and people kept saying this coin was the greatest thing ever.
They were giving price suggestions that weren’t based on anything. I discussed this with my roommate, who is always in favor of buying crypto.
Summarized: I was looking for confirmation.
Shortly after investing the value has dropped over 30% and I haven’t looked at it since. I’m in it for the long haul, so who cares about Lambo or moon. I will check my balance again in a few years – it might be zero or it might be unchanged.
Preventing Confirmation Bias
One great thing you can do to prevent or overcome confirmation bias is to seek out opposing viewpoints.
Challenge your current opinion and think about why you might be wrong. Challenge your own viewpoint until you have found some arguments against it.
When you’re making decisions like that, you will learn to ask yourself why you could be wrong – rather than the default: why you are right.
Always know the arguments for both sides and try to see all sides of a situation. You can practice this with your friends. When you’re having a discussion, take the opposing view.
It’s so much fun to challenge the existing viewpoint, and it’s a good learning experience as well!
2. Loss Aversion or Endowment Effect
Loss aversion states that people prefer avoiding losses over gettings gains. This goes hand in hand with the endowment effect, which states that people place a higher value on something they own versus something they don’t own.
This can be a very toxic combination and lead to irrational investment decisions.
While it’s okay to not sell every investment that’s not making a profit immediately, weigh it out with opportunity cost. If there is an extremely good investment opportunity passing by you, it’s a pity when you pass because you hope to make your money back on your current loss-making investment.
This is not something I’ve experienced so far, as I love to buy the dip, but my partner has. Again with cryptocurrencies – this is a fun investment category if you want to write exciting blog posts about behavioral biases lol.
My partner had invested just before the crypto bust in January 2018. To this day he is holding on to the cryptos because it would be possible for them to get their original value back.
While I’m not arguing with that, he has restrained investing in the stock market because of that. He doesn’t want to sell them for less than the value he bought them and would rather avoid further losses than taking this money and invest it somewhere else.
He has been missing out on investment return in the stock market because his money is still invested in cryptos.
When you’re trying to hold through the dip, good job – just realize that if you’re passing on other great investment opportunities, your return might suffer.
Preventing Loss Aversion and Endowment Effect
A good way is to see all past decisions as sunk costs.
Any decision to sell or retain the investment should be measured against the opportunity cost. When you want to make sure that you’re measuring against opportunity cost, tell yourself you can only have X amount of investments in your portfolio.
Our favorite investment guru Warren Buffett illustrates that we should act as if we have an imaginary ‘punch card’ if we want to achieve great investment results. This punch card has 20 holes, and every time you diversify to another investment you have to punch the card.
Buffett states that this would make investors think carefully before they make any investment. They would assess the risks better, which would lead to more informed investment decisions.
3. Overconfidence Bias
This bias is more about the tendency for people to believe that they have more knowledge on a certain topic than they actually have.
When it comes to investing, there are two types of overconfidence. The overconfidence that your quality of information is great, and your confidence in your ability to act on this information for maximum gain.
There is this study where they asked people how financially literate they are, 69% said they are financially literate. When they tested the subjects, only 24% resulted to have the basic financial knowledge and 8% had high financial knowledge.
That’s a little different than they thought.
It means that they think they’re able to make sound financial decisions with the information, while in reality, they aren’t always able to make the optimal decision.
This might result in less than optimal stock purchases, investments, savings, and more.
Besides that, overconfident traders trade more frequently and don’t always diversify their portfolios appropriately. Not diversifying brings a higher risk of having suboptimal portfolios.
When it comes to investing, it’s important to realize that there is not one single answer. No one really knows what is going to happen.
In this regard, it’s best to always keep buying. Trade your stocks at a fixed moment in time, for example, every month when your salary comes in.
‘Time in the market beats timing the market’ is a quote to live by.
Invest over a long period of time, invest in low-cost index funds, take advantage of dividends, and see your wealth grow over time.
Don’t believe your information is better than that of others. It isn’t.
4. Disposition Effect Bias
Disposition effect bias is all about selling your investment. It states that investors tend to sell winning investments and hold on to losing investments.
The tendency to sell when you have a winning investment is that you want to make sure you keep the returns you’ve already made. Berkeley has studied this effect, finding that in the months after selling your ‘winning’ investments they still outperformed the losing ones.
Selling your winners too fast can lead to not riding the full way up, leaving you with less than optimal investments.
The other side of the coin is holding on to your losing investments, hoping that they will start to do better again. This leads to losing out on investment opportunities since your money could be invested there instead of locked into the losing investment.
Personally, I have the tendency to sell too early.
I don’t invest in many individual stocks, but I’ve invested in 2-3 individual stocks at a particular time. One of those stocks rose from $100 to $130 and I decided to sell, thinking that it would not be a long-term position.
Later I found out that the stock had even gone up as much as $150, leaving potential gains on the table.
At this moment, it’s still not clear what is the full potential upside of this sold investment, but I know there could have been more upside to this investment.
Preventing Disposition Effect Bias
If you want to avoid holding on to losing investments for too long, you can decide what is the maximum amount of loss you’re willing to accept for any given investment.
Your nature of the investment should be the same. Meaning that for stock market investments you have another maximum loss, and in real estate, you have another maximum loss.
5. Familiarity Bias
Everyone knows the gains that are attached to a diversified portfolio. Despite that, investors prefer a familiar investment.
Familiar investments are investments in their own company, region, country, products that they love, services that they use.
Investors mostly invest in their home market, because they are relatively optimistic about the home market. Besides that, investors also prefer investing in their employer’s stock. That can be very risky!
Besides the risk of losses when the company performs poorly, you could also get a loss in compensation when that happens.
The most risk with the familiarity bias is that your portfolio doesn’t have enough diversification. The average investor prefers to invest in large-cap, employer, and domestic stocks. Research shows that optimal portfolios hold a minimum of 300 stocks for diversification purposes.
I doubt the average investor holds that many!
Prevent Familiarity Bias
When you’re investing, it’s important to be informed about the stocks you’re buying. Know where they’re coming from, diversify them, and reevaluate your portfolio every few months.
When you’re investing in low-cost index funds that are spread over the entire globe, you’ll have enough diversification for sure.
That’s my approach, investing in low-cost index funds that have sufficient diversification and different companies involved in them.
I buy my low-cost index funds, and I hold them until early retirement. That’s my way of dealing with these behavioral investment biases.
Have you dealt with any of these behavioral investment biases? How have you dealt with them?
Marjolein is a financial consultant who has built over €4,000 monthly passive income and saves over 70% of her income. Read Radicals’ inspiring story, from stuck in the 9-to-5 to loving life. Feel free to send Radical a message at the bottom of this page