Protecting your assets

The Psychology of Investing: Avoiding Six Common Behavioral Mistakes

23 Minute Read

We like to think of ourselves as rational investors, but sometimes our actions indicate otherwise. Despite education and experience, behavioral research suggests that the majority of people are subject to psychological biases, like the safety in numbers that might signal us to follow the herd. While often unconscious, these common biases can cloud our judgment and cause us to make decisions that are not in our best interest. The good news is that simple awareness of the behavioral pitfalls of investing is the first step to minimizing or avoiding them.

"Behavior finance matters because investors are predictably irrational; cultivating mindfulness around this helps to minimize unforced errors and capture opportunity."

Todd Lowenstein, Director of Research, HighMark Capital Management

Brexit offers a good illustration. In the two trading days following the U.K. referendum on June 23, 2016 to pull out of the European Union (EU), the U.S. stock market, as measured by the S&P 500, tumbled over 5%. Although the economic consequences of Brexit were unknown, let alone their impact on U.S. companies, panicky investors ran for the exits in a classic demonstration of several behavioral biases. Two weeks later, the market had fully recovered. But those investors who succumbed to these biases missed out on the ensuing rally or, worse yet, locked in a loss.

It is important to understand these emotionally motivated errors as they can lead to the same behavioral mistakes again and again. With a stronger understanding of behavioral finance, you will be better equipped to avoid these mistakes. In this paper we identify and explain some of the most common behavioral biases that lead to these errors. Additionally, we've selected six of the most common mistakes and offer tips on how you can avoid them.

 

Introducing Behavioral Finance

To comprehend the inherent emotional pitfalls of investing, it is helpful to first understand behavioral finance. Behavioral finance combines psychology and finance to analyze and explain why and how people make financial decisions. It attempts to explain the interactions between markets, emotions, personality, and reason.

The study of behavioral finance is a relatively recent one. The groundbreaking work was done in the 1970s by Daniel Kahneman and Amos Tversky, two psychologists who examined the quirks in human nature that cause people to act irrationally and against their own interests. Their initial research identified several patterns of irrationality—behavioral biases—that lie behind people's financial decisions and actions.

As others followed up on their research, many more irrational behaviors came to light. By the 1990s, empirical evidence pointing to behavioral biases had reached the point where behavioral finance was acknowledged as a legitimate field. And in 2002, Dr. Kahneman was awarded the Nobel Prize in Economics for his seminal work in the field.

Behavorial Finance graphic

Common Biases

Researchers have identified scores of different behaviors and biases that affect investing decisions. Here we consider seven of the most common. Some of these behaviors are closely related and can lead to the same mistakes. Others conflict with one another, underscoring the irrationality of human behavior.

Loss Aversion

Most people would prefer to realize a gain rather than incur a loss. But human nature goes a step further by making us react more strongly to losses than gains. In fact, a landmark study in 1995 found that investors felt 2.5 times as bad about a $1 loss as they felt good about a $1 gain. Put another way, they felt equally negative about a $1 loss as they felt positive about a $2.50 gain.

Recent studies on loss aversion focus on measuring that strong reaction to better understand its implications. One 2016 study by Schindler and Plattheicher finds that loss aversion can be such a strong psychological and neurobiological force that people are even more likely to act dishonestly to reduce the extent of a loss. Another 2019 study concludes that loss aversion can be both good and bad—e.g., “good” in the survival context; “bad” in an investment context. In fact, loss-aversion bias drives some of the most common investment mistakes, such as selling winning investments too soon and holding onto losing investments too long. Although it would seem logical to do the opposite, people are more concerned with losing previous gains or sidestepping future losses.

 

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How Loss Averse Are You?

Let’s say you are presented the same mutual fund by two different financial advisors.

Advisor 1: Highlights the fund’s average 12% rate of return over the past three years.

Advisor 2: Stresses the fund’s above-average returns over the past 10 years, tempered by its decline in more recent years.

Decision? Loss-aversion theory assumes you are more likely to buy the fund from Advisor 1, who presented the fund’s rate of return as an overall gain. And less likely to buy the fund from Advisor 2, who presented the fund’s performance as fluctuating significantly.

 

Anchoring and Conservatism

Anchoring can be found in everyday behavior. You shop for an appliance and use the price of the first model you see as a reference point for all subsequent choices, or maybe you refuse to pay more than a certain dollar amount for a certain item. Anchoring is even more common when dealing with more complex concepts such as investing. Setting a reference point provides a level of comfort and security, even if it may actually cause harm in the long term.

When making an investment decision, you have to start somewhere. The initial price or number you pick turns out to have a significant influence on your final decision. This "anchor" may not be current, logical, or even relevant to the decision, but you can become fixated on it and use that information to make inappropriate decisions.

An especially strong anchor is the purchase price of a stock. Investors tend to use the price they paid for the stock as an anchor point upon which they make a decision to hold or sell. For instance, if they bought the stock at $10 a share, that $10 price becomes their anchor point. Like loss aversion, this can lead to selling winners too soon and holding on to losers for too long.

A related behavior, conservatism bias, holds that people tend to cling to past information, even if new information is available or the investing landscape has shifted significantly. They become stuck and may even ride markets to the bottom if they cannot let go of what they think the price "should" be. For example, someone may decide that XYZ stock is underpriced just because it is below a level they have seen in the past, even though that past level is no longer relevant.

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Are You an "Anchorer"?

When thinking about selling a stock, do you say to yourself:

  • I will not sell this stock until I get my cost back.
  • This stock, at its 52-week high/low, looks very expensive/cheap.
  • This stock has not fallen to my last buying price, so I will not buy it until it does.
  • This stock has already risen a lot from my buying price, so I should sell before it falls.
  • This stock has already fallen a lot from my purchase price. How much more can it fall?

 

Availability/Overreaction

Availability bias is similar to anchoring in that it suggests that recently observed or experienced events strongly influence decisions. For instance, researchers found that individuals were likely to overestimate the chances of being in a car crash if they had seen a car crash on a recent journey. Likewise, shark attacks, big lottery wins, and other headline events affect our judgment, convincing us that a given prospect is more likely just because it is fresh in our minds.

In the investing world, people tend to subconsciously overweight events that have occurred recently. For example, investors may be more likely to be fearful of a stock market rout when one has occurred in the recent past. They may be more likely to take on more risk if the market has recently rallied, or less if it has recently fallen. Or, they may judge the quality of an investment based on information that was recently in the news, ignoring other relevant facts.

 

Herd Mentality

Following the crowd is a common behavior, shared by humans and animals alike. It can be very useful in many situations—but investing is not among them. Investors who follow the herd tend to buy a "hot" stock, or sell in a panic when the market drops. Instead of using their own information or making independent decisions, they simply do what others are doing.

The idea of herding is particularly relevant in the domain of finance. "Stock market anomalies, such as bubbles and crashes, are often created by investor groupthink and herding in one direction regardless of risk," notes Todd Lowenstein, Director of Research at HighMark Capital Management. Momentum investors attempt to take advantage of the herding instinct by basing buy and sell decisions on the "momentum" of a stock price. Contrarians, on the other hand, attempt to do the opposite, buying when other people are selling and selling when other people are buying.

Remember that it's not only about asking if it's a "hot" stock to own, but also if it's valued correctly. Think about it in relation to other important purchases—you wouldn't buy a car or a house without asking yourself that second question, but often with stocks people do not keep this in mind.

"Stock market anomalies, such as bubbles and crashes, are often created by investor groupthink and herding in one direction, regardless of risk."

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Do You Follow the Herd?

  • Do you read the "most read" news stories first?
  • When choosing a restaurant, do you tend to go to the one that is most popular?
  • When you hear of a "hot" stock, do you buy it?
  • When the market has a sustained rally, do you buy because "everyone else is buying"?
  • When the market drops, do you rush to sell?

 

Overconfidence

Self-confidence is generally considered to be a positive trait that makes people happier and helps them succeed. But too much of it can be a bad thing, especially when it comes to investing.

Research shows that almost everyone displays overconfidence to some degree. We tend to overrate our abilities, knowledge, and skill. For example, surveys have shown that much more than half the population claims to be above-average drivers, or have an above-average sense of humor. Other studies have found that men tend to be more overconfident than women, that the relatively young are more overconfident than the relatively old, and that highly overconfident people tend to have a higher risk tolerance. In one 2012 study, nearly two-thirds of investors surveyed rated their financial sophistication as advanced, yet respondents scored just 61% on a financial literacy test.

Overconfident investors tend to mistake luck for skill. They place too much confidence in their own investment decisions, beliefs, and opinions. They see success as something that they caused, but blame setbacks on external forces. They trade more actively than they should. They also tend to chase returns, underestimate risk, and overestimate their investment results. Such behaviors can lead to costly mistakes and can take a dramatic toll on long-term portfolio performance.                    

 

Confirmation Bias

Most of us think of ourselves as open-minded. But human nature makes it difficult to reject existing opinions. We instinctively filter out the information that doesn't support our preconceived notions. Behavioral psychologists refer to this as confirmation bias. It is similar to anchoring and availability bias, but refers specifically to our innate tendency to favor information that confirms preconceptions.

For example, someone who prefers a particular product brand will tend to seek out reviews that favor that brand. Or, when investing, confirmation bias may occur when a portfolio is highly weighted in the stock of a company where we work. As employees, we are constantly reminded of the company's virtues and subconsciously seek evidence to support its success—sometimes to justify an oversize position, even if it may expose us to greater portfolio risk.

Like other behavioral biases, confirmation bias works subtly. Even those who spend an equal amount of time analyzing the pros and cons of an investment tend to give more weight to the pros if there is already a preconception in favor of it.

 

Familiarity Bias

When people are offered two alternatives, they generally prefer the one that they are more familiar with. In investing, that means there is an inherent bias toward investments we know, and against those we don't. We also tend to associate familiarity with lower risk, even if that may not be the case.

In fact, the more familiar investors are with a security, the more likely they are to buy it. Familiarity bias helps to explain why so many investors favor "blue chip" stocks or stocks of companies with familiar household names. Or, they tend to buy shares in the companies they work for. It also helps to explain why many people overweight or confine their investments to domestic securities, local companies, or those of a familiar sector or cultural leaning.

But when you confine yourself to the familiar, you may under-diversify your holdings or underestimate the amount of risk in the investment. This can lead to a lopsided portfolio, one with an inappropriate asset allocation or a greater risk of loss.

CHECK IN:

How Familiar Are Your Investments?

When you consider your entire investment portfolio, do you find that:

  • A large share of your stock holdings is in the companies you have worked for?
  • You have a disproportionate holding of one or two stocks that you know well?
  • Your investments are confined to companies with nearby headquarters?
  • You invest primarily in companies that are well-known household names
  • Your investments are limited to domestic securities?

 

Six Common Investing Mistakes—And How to Avoid Them

These biases can ultimately lead to poor decisions and investing mistakes. "Left unchecked, subconscious biases produce a powerful tendency toward mistakes and counterproductive decisions. Investors need to recognize these potential pitfalls and use investment discipline to guard against these potential outcomes," notes HighMark Capital Management's Todd Lowenstein.

Below are six of the most common investing mistakes, how they relate to the different biases we just described, and suggestions on how to avoid them.

1. Trading Too Often

Frequent trading can be the product of several different behavioral biases, especially overconfidence. If you find yourself checking your portfolio balance every day and tend to buy or sell on the market’s ups and downs, you are probably doing yourself a disservice. Trying to time the market is generally a losing strategy. In fact, an overwhelming 92% of financial professionals fail to beat the market over time.

Evidence shows that the more frequently you look at your portfolio, the more likely you are to trade. And the more you trade, the more likely you are to reduce your overall return.

A buy-and-hold strategy may be more appropriate, especially for long-term investors.

2. Selling Winners, Holding Losers

One of the investing practices attributable to a number of different biases is the tendency to sell winners too soon and hold onto losers for too long. A simple way to avoid such missteps is to set investing parameters. For instance, establish criteria for when to sell. If your investment price rises by more than a certain percentage, sell it or reassess whether it is worth keeping. Ask yourself: If you did not already own this, would you buy it at today's price? Likewise, if an investment sustains a loss, set a threshold beyond which you will sell. Setting limits like this will help you deal with biases such as loss aversion, anchoring, and overconfidence.

3. Investing High, Selling Low

Buy low and sell high would seem to be a fundamental strategy for most investors. In reality, many—notoriously, retail investors—tend to do the opposite. Net inflows to equity funds tend to increase when stock prices rise, and net outflows tend to occur when stock prices fall.

A classic example of such behavior is the buying frenzy during the late stages of the tech boom—when the NASDAQ Composite soared more than 85% in 1999 alone.

Such behavior can be the result of several biases, including overconfidence and herd mentality. If you find yourself tempted to buy at top price or sell in a slump, make sure to first consider metrics such as price/earnings and other valuation measures. Also, consider past bubbles and busts. Above all, be wary when someone says, "This time it's different."

4. Under-diversifying

Often associated with familiarity bias, lack of diversity in a portfolio may have serious consequences, exposing you to higher risk and potentially dramatic market swings. While there is no one rule for how much you should diversify, your portfolio mix should be a function of your goals and overall tolerance for risk. Advisors typically suggest diversifying by asset class as well as by individual investments. Pooled investments, such as mutual funds or exchange-traded funds, may help with the latter. Keep in mind however, that diversification is no guarantee of a profit or assurance against loss.

While there is no one rule for how much you should diversify, your portfolio mix should be a function of your goals and overall tolerance for risk.

 

5. Focusing on the Short Term

Availability bias helps explain why investors tend to overweight short-term information and events. But modern day instant communications and emphasis on short-term results also play a role. Quarterly earnings announcements, monthly and weekly economic statistics, up-to-the-minute market updates—;all focus our attention on the short term. This barrage of information can create psychological anchors in thought processes, leading to investing decisions that may not be in keeping with our long-term goals. Long-term investors are better served by staying focused and not getting caught up in everyday noise or overreacting to short-term volatility.

6. Going It Alone

Overconfidence and familiarity bias can cause us to make important investment decisions in a vacuum. Whether it is from a trusted friend or a professional advisor, getting a second opinion is almost always a wise move. And don't be afraid to rely on others who may be better qualified to make investing decisions for you. They may be able to short-circuit some behavioral biases and keep you focused on your goals.

 

The Bottom Line

Just recognizing when you are making decisions based on behavioral biases is half the battle. When choosing, buying, or selling investments, it helps to step back and consider why you are making a given decision. Ask yourself: What is my decision based on? If, instead of drawing from objective facts and reasoning, you find yourself "going with your gut," try to identify which behavioral biases might be at work and how they might be clouding your judgment.

 

Your Financial Partner for Life

If you recognize some of these biases in yourself, or find yourself prone to these mistakes, The Private Bank is here to help. We are dedicated to helping our clients achieve their financial goals and dreams. Drawing on a tradition of excellence, personalized service, discretion, and respected investment experience, our teams offer specialized financial services to meet all of your needs—including banking and investment management services, specialty asset management, and trust administration services—no matter how complex.

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