Behavioral finance biases….where do I begin? This article will present financial pitfalls, some of which I have learned through my own experience. Below are seven behavioral finance biases that you must avoid!
Click to jump to a section:
- #1: Endowment Effect
- #2: Loss Aversion Bias
- #3: Confirmation Bias
- #4: Familiarity Bias
- #5: Self-Attribution Bias
- #6: Recency/Trend Bias
- #7: Bandwagon Bias
If you have already fallen into some of these, it’s ok. Stop, find your way out, and get going in the right direction!
Behavioral Bias #1: Endowment Effect
The Endowment Effect quite possibly has the greatest opportunity to trip you up in your investing journey. I wrote about this at length in my previous post, but in short, the Endowment Effect is when you place a greater value on something you already have over something you are looking to buy.
For instance, a blanket you owned throughout your childhood might be worth a lot to you. However, someone simply buying it to stay warm may not value it as highly. You have a perceived, non-monetary reason to value it more than others.
Many studies have been done on this, with one of the most famous examples being where a group of people was split into two groups, half of which were given a coffee mug and the other half were not.
The group with the mug was asked what price they’d be willing to sell it for, and the other group was asked how much they would pay to buy it. The sellers said they’d sell for $7.12, and the buyers, on average, were only willing to pay $2.87 – a difference of $4.25!
This is primarily impactful during investing when you hold onto a stock because you already own it.
Maybe it’s a stock you wouldn’t buy currently but don’t think you should sell. You’re only holding onto it because you already have it.
This is ludicrous!
If the stock isn’t good enough to buy, it’s bad enough to sell. Move that stock into a new company worthy of your personal ‘buy’ rating and reap the rewards.
Behavioral Bias #2: Loss Aversion Bias
For young investors, Loss Aversion Bias can potentially be the most damaging long-term behavioral finance bias.
The general concept is that losing money is way more painful than gaining it. Personally, this has been the hardest lesson for me to learn. When I first began investing, I decided that day-trading was my best option (like an idiot). Fortunately for me, two great things came out of this:
- I broke even. I gained a lot at the beginning but then lost a lot and decided day trading was not a good idea
- I learned a very valuable lesson in addition to the fact that I am not a day trader. I learned that losing money hurts much more than gaining it!
I heavily invested in a stock I still own, and the returns slowly crept up to over 10% gains in a very short period, like a week or two. Then, I lost all of that money in one day. The losses were awful.
Yes, I had only gained a small amount of money and immediately lost it, but I noticed something. I noticed that my mindset when I gained the money was that investing was easy and that the money was guaranteed never to go away. How stupid was that? I completely broke even (luckily), but I felt like I had just been KO’d by Floyd Mayweather.
This bias will cause investors to invest with not only a margin of safety as Andrew and Dave recommend but such a margin of safety that they’re constantly underutilizing their money and missing out on huge returns!
This would be like a 25-year-old investing in bonds. Yes, you get a guaranteed return. Unfortunately, your guaranteed return is also essentially guaranteed to underperform long-term.
The younger you are, the more time you have to be aggressive.
Don’t be so scared of losing money that it hurts your returns. I promise that losing $5 is the exact same, but opposite, of gaining $5, even if it seems like a much harder pill to swallow.
Behavioral Bias #3: Confirmation Bias
Confirmation Bias is another very common mistake that investors will make. Andrew and Dave have often discussed the importance of looking at the numbers and using the Value Trap Indicator (VTI). The VTI helps decipher if a business has healthy fundamentals and shapes your decision on whether you should invest in it.
Unfortunately, many investors already have preconceived notions about stocks before they even start to look at the numbers. This can cause them to have blinders on and become a victim of confirmation bias.
For instance, the investor might be a dedicated, brand-loyal customer of a company like Apple, Coca-Cola, or Lululemon. Their mind might be made up – they will buy some stock, dangit!
But – they want to make sure the numbers look good. So, they take a look, and maybe the P/E is higher than they want, revenue isn’t increasing at their preferred rate, or maybe they have a ton of debt on the balance sheet. Regardless, you look past all of those because their EPS is growing, but only because they’ve bought back shares. So, the actual earnings are staying flat or even declining. “Since their EPS is growing, that’s really all that matters, right?”
This thinking can lead you to ignore red flags and focus on seemingly positive indications. At best, this might work in the short term, but it won’t lead to long-term results.
Behavioral Bias #4: Familiarity Bias
This behavioral finance bias occurs when you stick with what you know, and it can result in your portfolio not being diversified, leaving you at a greater risk.
I, personally, am not one to discourage risk if you have a long time frame, such as retirement 20 years from now. However, you should take on that risk intelligently and make sure you understand the risk. This is not the case if this is an unconscious behavioral finance bias.
A great example of this would be that if you’re really into the fitness community, you only invest in fitness stocks. Yes, you can diversify between apparel, nutrition, etc., but this still can leave you with a lot of exposure.
You will see this extremely frequently with people’s work. Chances are, you know the industry you work in better than other industries, leading you to invest in that industry more frequently.
I think this is the scariest possible situation because your investments are under-diversified, and you’re also employed in that same industry. If bad things happen to the industry as a whole, such as online shopping to retail, this could be disastrous for your retirement income and your income!
You won’t find a home run if you keep hitting the ball the exact same way.
Yes, I always encourage you to invest in what you know – but make sure you’re branching out, learning new industries, and diversifying your portfolio.
Behavioral Bias #5: Self-Attribution bias
I see this behavioral finance bias occurring all the time! You will notice this when someone attributes their portfolio gains to their own “wisdom” and the losses to bad market conditions…aka, all of the credit and none of the blame.
It’s like taking credit on Apple for their huge boom throughout history but then selling a few weeks ago and blaming it on the tariff war. When you think about it, doesn’t it sound like something you might hear on TV? Just some food for thought.
As much as we like to think so, none of us are perfect. Sometimes we will fail to predict something out of our control, or we make a good move. Either way, take accountability for your actions.
When it comes down to it – the highs and the lows are all on you as an investor. You might have invested in the right stock at the right time, wrong at the wrong time, completely guessed and got lucky or completely guessed and were wrong – end of the day, it’s your money and you really are the only one that can take accountability for how your portfolio performs – good or bad.
Behavioral Bias #6: Recency/Trend Bias
Day traders and technical analysts use recent events to strongly influence their investment decisions. I know that there are technical analysts and day traders who are very successful. However, they apply the trend to a proven system rather than get influenced by a trend to abandon their system.
I’ll give you an example.
When I was a newcomer, I thought that I could simply look at the charts of a stock, such as the dips and the tops. Using this to gauge its performance, I could try to predict where the stock price was going next. It was essentially an elementary version of what technical analysts do; VERY elementary.
I had no idea at all what I was doing, but I was biased in my beliefs that the stock market was predictable if you understood the past.
While the past can and will help you learn and make future decisions, you should always understand that the future will not always look like the past, and that this is an extremely risky thought process to follow, especially if this is your side hobby and you’re not fully dedicated to this like someone that watches the trends as a full-time job.
Behavioral Bias #7: Bandwagon Bias
Whenever I talk to my friends they talk about how they want to find the “next big thing.” Well no crap. Don’t we all want that?
The issue is that I see those same friends almost always overpaying to try to “get in at the ground floor,” which is actually usually after the stock has surged immediately following their IPO.
By the time you realize that a stock is shooting up, so has everyone else. You will never be the very first person to invest in a home run. Chances are if it seems like an obvious home run to you, it’s already too late.
I have a friend that bought Beyond Meat at $190. So, he waited until the stock had gone up more than 7x its IPO price of $25 and then decided to buy an overpriced stock because he didn’t want to miss out on the hype.
This is the DEFINITION of the Fear of Missing Out (FOMO).
FOMO is a real thing, and it can cause people to do some crazy, irrational things that they might not normally do. It’s easy to become infatuated with a product or company, see crazy growth, and have all of your friends talking about it. It’s always on the news (am I describing cryptocurrency?), and the hype is unreal. You become so distracted that you forget all your investing fundamentals and buy a stock completely blind and then pray that it works out.
I don’t know about you, but that’s not my investing strategy. Take your time, stick to your beliefs, and avoid the hype!
The Bottom Line
All in all, any of these behavioral finance biases are very easy to get wound into. I still, at times, will find myself wandering down a certain path.
For example, when the market goes down and I blame the trade tariffs, or when the Uber IPO came out and the executives say the company will never make money. Nevertheless, it is so easy to get caught up wanting to invest regardless.
Be disciplined. Stick to your values and your investing strategy and always, always, always invest with a margin of safety – emphasis on the safety!