Better Understanding Behavioral Biases

Behavioral finance plays an important role in understanding the importance of having an investment plan and sticking to it. To understand why it’s important to have an investment plan in place, check out our recent blog post here – this week we’re diving into behavioral finance and the specific biases many investors exhibit.

Behavioral finance is the study of how psychological influences can affect you when making investment decisions. It assumes investors are “normal” in that they make rash investment decisions based on emotion and biases. 

This is contrary to traditional finance which assumes all investors are “rational” and their decisions are logical, centered on a defined goal and objective, free of emotion, and take into account all information available. Essentially, everybody acts in a perfect manner, and any divergence from rational behavior is considered an anomaly which can be easily and quickly corrected.

Because humans are complex and imperfect by nature, most of us fall under the “normal” investor category which assumes we are prone to making cognitive mistakes due to our beliefs or biases. 

For reference, below are a few examples of typical cognitive biases:

• Herd Mentality – People tend to follow the masses, or the “herd”.

• Familiarity Bias – Investors tend to underestimate/overestimate the risk of investments with which they are familiar/unfamiliar.

• Hindsight Bias – Looking back after the fact is known and assuming once can predict the future as readily as they can explain the past.

• Gambler’s Fallacy – Investors often have an incorrect understanding of probabilities which can lead to faulty predictions. E.g. An investor may sell a stock after multiple successful trading sessions as they may not believe the stock will continue on its upward trend.

• Similarity Heuristic – Used when a decision or judgement is made when an apparent similar situation or scenario occurs even though the situation may have a very different outcome.

• Naive Diversification – The process of investing in every option available to the investor. (This usually happens within a 401(k) when investors are limited to a set of funds to choose from).

Do any of these descriptions feel familiar with your investment experience? If you’ve ever fallen victim to one of these examples, or any of the other many cognitive biases that exist, just know you’re not alone. It’s in our human nature to make decisions based on our own experiences, beliefs and biases. 

With that being said, it’s crucial to understand the negative impact these biases may have on the overall outcome of your portfolio so you can account for and correct them. Too often, investors make the wrong decisions at the wrong time because they get caught up in their emotions, unable to see the light at the end of the dark tunnel. 

In fact, the 2020 QAIB Report issued by DALBAR showed the average equity investor has underperformed the S&P 500 by an average of 1.81% per year over the past 20 years due to bad investor behavior. To put this in perspective, if you started with $1,000,000 in your portfolio 20 years ago, this would result in a difference of about $500,000 today (half of your original portfolio value)! 

The underperformance has been even more prominent in recent years with increased market volatility. Having an investment plan in place is a good way to combat this trend.

Furthermore, this highlights the importance of working with a professional and ensuring once you have committed to an investment plan, you have someone to hold you accountable to sticking to the plan for long-term success. Sticking with a long-term plan can help you avoid these biases and the adverse effects they can have on your overall financial plan.

Ben Webster, CFP® and Derek Prusa, CFA, CFP®

Co-Founders and Owners of Aspire Wealth