As human beings, our decisions are based on a mixture of facts and beliefs. This can extend to the decisions we make, including investment decisions. Behavioral finance theorizes that these psychological biases play a large role in our economic and financial decision-making. Investment biases are psychological effects that may impact the choice to buy, sell, and hold securities.
Common Investment Biases
Confirmation bias occurs when someone seeks out or gives additional weight to information that confirms a personally held belief. Instead of researching opposing data points and facts, value is placed on data that supports a preconceived conclusion. One example of this is if an investor believes a stock will do well and thus seeks out news articles that also say the stock will perform well. In order to help avoid confirmation bias, preconceived conclusions that are not based on facts and figures should be researched and facts and data should be examined on both sides to help determine if one can give the information fair consideration.
Loss aversion is a bias representative of increased sensitivity to losses than to gains. The negative feelings associated with realizing losses can cause an investor to delay selling a falling security, because selling makes the loss feel “real”, or even take on less risk initially that may be necessary to achieve a specific financial objective. The human mind inherently does not want to lose, and loss aversion bias can impact how much an investor chooses to invest and the timeline of when they choose to sell a security.
Overconfidence creates an investing bias when an investor overestimates their own abilities – whether in predicting trends, thinking they know how the company will perform, or the best times to buy and sell. A common investing bias, it can be damaging to portfolios when investors overestimate their “sixth sense”. This can also be a direct impact of confirmation bias as the “confirmed” ideas take precedent and could lead to an investor’s increased confidence. Overconfidence can lead investors to take on risk not suited for their portfolio, underestimate impacts, and can be rooted in the falsity that one person can control the market.
Familiarity bias is rooted in the human tendency to gravitate towards people, places, and things that we are familiar with. This extends to investing in familiar products or industries to help avoid uncertainty. However, familiarity bias directly contradicts the fundamentals of diversification and could potentially cause investors to invest in a fewer number of sectors and industries, or even exclusively invest in one industry.
Anchoring bias can occur when an arbitrary data point or piece of information is focused on heavily, to a fault. One example of a commonly “anchored on” data point is the share price. In the public market, one example would be a stock trading at $90 per share. An investor operating under anchoring bias might say “I’m going to wait until the share price drops to $80”, but the next day the price increases to $100 per share. There is no logical reason that the share price will fall, but the investor has anchored his investment decision on the single data point of share price. The share price became irrationally significant, and the anchoring bias acted unfavorably to the investor’s goal.
Survivorship bias is rooted in the tendency for humans to pay attention to the outcomes that “survived”. Investors have the tendency to remember the companies and stocks that performed well and forget the companies and stocks that failed. Index Fund Advisors put together the following chart on survivorship based on the SPIVA® U.S. Year End 2021 U.S. Scorecard. A majority percentage of funds did not survive, but they were generally forgotten in a record year for venture capital.
They say hindsight is 20/20, and hindsight bias can cause people to attempt to predict future outcomes based on past events. An investor anticipating a market crash may believe they accurately predicted the timing of the crash when it does occur. Markets are volatile and past performance and events may not predict future events.
Fear of missing out, or FOMO, occurs when someone makes an investment decision based on what the majority of investors are doing. This can lead investors to make uninformed investment decisions that may not be suitable for their portfolio. To learn more about FOMO investing, check out our recent blog Avoiding the FOMO Effect.
Biases in investing are bound to occur, but investors can take steps towards helping to mitigate the risk of these biases – one being awareness. Once investors are informed of the different biases that occur, they can be aware of the effects they may have and take steps to pursue a logical process and research before making investment decisions. Otherwise, investors may expose themselves to situations that are not suitable for their portfolios. Investing involves risk, the market is volatile, and it can be difficult to predict the outcomes of investments.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.