Investing can be just as much a behavioral process as is can be a quantitative one. To be a truly great investor over the long-term one needs to be able to recognise and correct their own behavioural biases. This article will look at some of the most commonly taught behavioural biases with examples and corrective strategies.
While this is by no means an exhaustive list from the dozens of potential biases taught in behavioral finance courses at college or the CFA program, they are some of the most relevant to individual retail investors and a great way to start the self-exploration journey. Everyone has biases, get to know how to call yours out and correct them when necessary!
Anchoring Bias: The analysis is being overly influenced by one centric piece of information that the investor is fixated on. This piece of information might be one of the first things learned about the company or simply an old historic price which a stock used to trade at before fundamental changes took place in the business. To help investors not fall prey to anchoring bias, they should always keep current with the company and industry news as well as be willing to accept new, and possibly contradicting, information.
Availability Bias: The decision is being based on experiences and information that have the most resonance with the investor. This could take the form of mainly investing in companies widely talked about in the news rather than researching the most undervalued stocks. Availability bias is also present when basing decisions on the most well-known and advertised investment funds rather than choosing the best performing but lesser known fund manager. To help avoid availability bias, investors should always be making decisions after analyzing a variety of options and should use stock screeners to help uncover new companies they might not be familiar with.
Confirmation Bias: The investor only looks for additional information that confirms their current opinion. This means the investor is only seeing one side of the story and is not aware of negative opinions or worse-case scenarios. One corrective action to get over confirmation bias is to always actively search for points which contradict your opinion. This ensures that you are exposed to the other side of the conversation and will take those probabilities into account.
Conservativism Bias: The investor is reluctant to change their view and is slow to incorporate new information into their analysis. Conservativism bias differs from anchoring bias because the investor will slowly, or partially, incorporate the new information with conservatism bias but would not do so at all with anchoring bias. A corrective action for conservativism bias is to write down your thesis and valuation on why you bought the stock in the first place. As the factors in your thesis change, adjust your valuation accordingly.
Loss Aversion: One of the most common biases where the investor is more psychologically hurt by recognising losses than they would be with realizing the equivalent gains. Investors with a loss aversion bias will hold onto losing stocks as they continue to decline but will also be inclined to sell gains too early in order to cement the gains and avoid any pullback. A corrective action for investors to avoid loss aversion bias would be to always update their valuations with new information before making a decision.
Recency (Representative) Bias: When people tend to overweight the most recent observation rather than a larger set of observations, this is called recency bias. This cognitive bias can also be referred to as representative bias as the person is wrongly assuming the small sample size of data points is representative of a larger population.
This type of thinking can cause investors to think that a market downturn (or upturn) will continue long into the future rather than revert to more historic valuations. Falling victim to recency or representative bias can cause investors to get side-tracked from their long-term financial plans. Remember to take into account the long-term profitability of a company over a business cycle and not get caught up in the latest quarter.
Regret Aversion: The fear of making a mistake can cause people to act in odd ways or even freeze and not act at all. Past mistakes can influence an investor’s decision to be more cautious (or more aggressive) in the current situation if they previously behaved the opposite way and that caused losses (or made them miss out on potential gains). Regret aversion can even be present when investors choose to make no decision and continue to hold the stock or sit on the sidelines. Here the investor is wrongly thinking that by making no decision, they will have no regrets. However, a better and more informed decision could have been made based on fundamentals.
The commonly mentioned fear of missing out (called FOMO for short) is a type of regret aversion bias where investors continue to hold, or even buy, a stock even though the fundamentals do not support the decision. This type of behaviour is often associated with bubbles where investors continue to flock to certain stocks as they regret not being invested earlier and missing out on gains. The same patterns can happen on the downside too when stocks are falling rapidly causing them to cross below their intrinsic value. In this situation, investors are now dumping positions as they regret being invested.
Social Proof: Investors base their decision on the endorsement of others or common beliefs of the group. The classic example would be investing in a company based on cocktail party conversation with friends who are invested without doing any due diligence yourself. Social proof bias is one of the causes of herding behaviour by investors towards particular stocks or industries. Always do your own research before making an investment decision and take other people’s recommendations with a grain of salt.
Educating yourself on the various types of behavioral biases can make you a better investor and help you not get sidetracked on the way to reaching your long-term financial goals. Always remember to frame each decision independently of past failures or successes and base decisions on fundamentals. Prepare and update your valuations before making any decisions and always do sensitivity analysis with worst-case scenarios to know the other side of the conversation. For investors interested in a pre-built financial model where they can punch in the financial data of any company of interest, they can check out our financial model and valuation template!