7 Common Biases That Impact Investors
Investors exhibit many biases. Few of these behavioural biases exist in isolation because deep interactions exist among different biases. Nonetheless, the following list represents some common biases facing investors but others may be equally important depending on the specific situation.
1. Representativeness.
Representativeness results in investors labelling an investment as good or bad based on its recent performance. Consequently, they buy stocks after prices have risen, expecting those increases to continue and ignore stocks when their prices are below their intrinsic values.
Investors should have a clearly defined analytical process that they test and retest in order to refine and improve it over the long run.
2. Regret (loss) aversion.
Regret aversion describes the emotion of regret experienced after making a choice that turns out to be either a bad or inferior choice. Investors who are influenced by anticipated regret are motivated to take less risk because this lessens the potential for poor outcomes. Regret aversion can explain investor reluctance to sell “losing” investments because it gives them feedback to make bad decisions. Disciplined investing requires overcoming the reluctance to realise losses.
3. Disposition effect.
Closely related to regret aversion is the disposition effect, which refers to the tendency of selling stocks that have appreciated in price since purchase (“winners”) too early and holding on to losing stocks (“losers”) too long. The disposition effect is harmful to investors because it can increase the capital gains taxes that investors pay and can reduce returns even before taxes.
4. Familiarity bias.
This bias occurs when investors have a preference for familiar investments despite the seemingly obvious gains from diversification. Investors display a preference for local assets with which they are more familiar (local bias) and portfolios tilted toward domestic securities (home bias).
To overcome this bias, investors need to cast a wider net and expand their portfolio allocation decisions to gain wider diversification and risk reduction.
Investing internationally helps to avoid familiarity bias.
5. Worry.
The act of worrying is an ordinary and unquestionably widespread human experience.
Worry educes memories and visions of future episodes that alter an investor’s judgment about personal finances. In turn, this concern increases the likelihood that investors will not buy security. To avoid this bias, investors should match their risk tolerance level with an appropriate asset allocation strategy.
6. Anchoring.
Anchoring tends to hold on to a belief and then apply it as a subjective reference point for making future judgments. Anchoring occurs when an individual lets a specific piece of information control their cognitive decision-making process.
Many investors still anchor on the financial crisis of 2007–2008 as a bad experience. To avoid anchoring, investors should consider a wide range of investment choices and not focus their financial decisions on a specific reference point of information.
7. Trend-chasing bias.
Investors often chase past performance in the mistaken belief that historical returns predict future investment performance. Research demonstrates that investors do not benefit because performance typically fails to persist in the future.
To avoid this bias, investors should resist following the herd or jumping on the bandwagon. Although investors may feel better when investing with the crowd, such an investment strategy is unlikely to lead to superior long-term performance.
These seven behavioural biases are some fundamental issues investors might face at different periods during their lifetimes. Another important issue to consider is the amount of attention and time they should spend on their investment decisions because this might result in overconfident or status quo behaviour.
“By avoiding behavioural biases, investors can more readily reach impartial decisions based on available data and logical processes.”
