Good investors are disciplined and not impulsive.
Most people would agree with that statement, but did you know that all investors have biases? Recognizing your biases will make you a better investor.
Let’s start with the common biases discussed within the financial industry. As you read through the list, determine if any of them are impacting your investment decisions.
Overconfidence:
If your investments have performed well since early 2009 (the end of the 2008 financial crisis), you may conclude that you are a talented investor. But the reality may be that the overall U.S. stock market has performed very well. Being overconfident can lead to taking more risk than is prudent or neglecting the potential downside of investments.
Herding: As humans, we do not like to go against the crowd. We tend to follow the herd, which can be dangerous for our investment accounts. Herding is common within the financial industry and within the media. Numerous financial journalists write on the same topic, and the latest trendy subject has been euphoria as Americans emerge from the pandemic. Herding has led to a phenomenon called FOMO, the “fear of missing out.” If you read repeatedly that the U.S. stock market will soar during the next few years, you may take more risk than is wise. It is far better to educate yourself so you can make your own decisions and avoid the pressure to follow the herd.
Loss Aversion: Research has shown that investors feel losses two and a half times more strongly than gains. Loss aversion is also impacted by the way our brains are “wired” and whether our prefrontal cortex calms down the warnings coming from our amygdala when the U.S. stock market plummets or a crisis occurs. This involves neuroscience, which impacts all investors. Some people can calm themselves down better than others (and use the signals from their prefrontal cortex to remind themselves they have a long-term plan so they do not need to overreact to volatility in the stock market). If you lie in bed at night worrying when the stock market becomes volatile, then loss aversion may be at the core of your stress and you should not be overly aggressive in your investments.
Short-term Focus: I see this risk in clients who are preparing for retirement. They may think their “time horizon” is two years (until their retirement date). I explain to them that their true time horizon is until they die, which may be 30 years or more. Their investments need to work for them and help them thrive throughout a long retirement period, which typically means a long-term focus.
Hindsight Bias: This bias often involves anger and regret. If you sold all your investments in late 2008 or early 2009, at the lowest point in the U.S. market, you likely feel regret. By selling at the low point, you maximized your losses, and missed the recovery that occurred during the following several years.
If you had invested heavily in technology companies in year 2000, you likely experienced large losses as the technology sector declined over 80% between 2000 and 2002. If you had invested in Enron, Worldcom, and Tyco you would have experienced regret (and likely anger too) because these firms imploded in 2002.
All investors make mistakes, but we can learn from them. If you acknowledge your mistakes (your hindsight bias), then it can help you prevent future errors.
Personal Bias: This bias involves the way we were raised and our life experiences. I was raised in a middle-income household in the Midwest. We did not have fancy clothes and I did not attend private schools, but we were never hungry. My father often said “Money doesn’t grow on trees” “save for a rainy day,” and “live within your means.” Clearly, this upbringing impacted me, and as a result, I am a conservative investor. I respect the stock market, but I do a significant amount of due diligence before I invest. Think back to the “money messages” you learned as a child, and how these have impacted your financial decisions as an adult.
If you were raised in a household where there was never enough money to last until the end of the month, that experience helped shape you and your behaviors (and biases) today. Conversely, if you were raised in a household where money flowed freely, or where relatives “won big and lost big,” that will impact your behavior as an adult.
A recent factor that falls under personal bias – which seems to be impacting young people – is pressure from social media or “influencers.” This has led young people to buy speculative stocks such as GameStop, on platforms such as Robinhood. Investments in Bitcoin and other cryptocurrencies are also considered speculative by most seasoned investors.
Personal bias can include what you read (online, or in books or newspapers), or watch on TV. I read The New York Times and The Wall Street Journal daily, which impacts my investment style. If I watched Jim Cramer or CNBC, I would invest very differently. I am much more likely to listen to advice from Warren Buffet than Elon Musk. I acknowledge that I am biased.
Wise investing is a learned behavior. By acknowledging your biases and committing to learning about finances, you can become a successful investor.