Behavioral finance biases….where do I begin? Is this really an article about potential pitfalls that you might experience or is it a biography about my first experiences investing? Either way, below are seven behavioral finance biases that you MUST avoid!
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 posting, but in short, the Endowment Effect is when you place a greater value on something that you already have over something that you are looking to buy.
For instance, a blanket that you own that you had throughout your childhood might be worth more to you than someone that is wanting to purchase it for the sole reason of keeping warm. You have a perceived, non-monetary reason to place a higher value on it that others do not.
Many studies have been done on this, with one of the most famous examples being where a group of people were 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 seller’s 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 that you wouldn’t buy currently, but you don’t think you should sell. You’re holding onto it literally only because you already have it.
This is ludicrous!
If the stock isn’t good enough to buy, then it’s bad enough to sell. Move that stock into a new company that is worthy of your own personal ‘buy’ rating and reap the rewards.
Behavioral Bias #2: Loss Aversion Bias
To 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 the best option for me (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 so much more than gaining it!
I heavily invested in a stock, which 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 literally lost all of that money in one day. The losses were awful.
Yes, I had only gained a very small amount of money and then immediately lost it, but I noticed that my mindsight when I gained the money was that investing was easy, and that the money was essentially guaranteed to never 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.
The unfortunate part is that your guaranteed return is also essentially guaranteed to underperform on a long-term basis.
The younger you are, the more time that 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 tougher pill to swallow.
Behavioral Bias #3: Confirmation Bias
Confirmation Bias is another very common mistake that investors will make. Andrew and Dave have oftentimes talked about the importance of looking at the numbers and using the Value Trap Indicator (VTI) to decipher if a stock is under/overvalued to help shape your decision on if you should invest in it or not.
Unfortunately, a lot of investors already have preconceived notions about stocks before they even start to look at the numbers, and that can cause them to look with blinders on and become a victim to 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’re going to buy some stock, dangit!
But – they want to make sure the numbers look good. So, they start to take a look, and well, maybe the PE is higher than they want, or revenue isn’t increasing at their preferred rate, or maybe they have a ton of debt on the balance sheet – but 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?”
Congrats – you are now a confirmed Confirmation Bias Victim!
You have unintentionally ignored some major red flags, focused on what seems like a positive, and used that to justify your “financial” method of evaluating the company. Maybe it works out for you – odds are, it won’t.
Behavioral Bias #4: Familiarity Bias
This behavioral finance bias occurs when you really stick with what you know, and it can result in your portfolio not being diversified, therefore leaving you at a greater opportunity of risk.
I, personally, am not one to discourage risk if you have a long time-frame, but you should still take on that risk intelligently, and making sure you understand the risk, which is not the case if this is an unconscious behavioral finance bias.
A great example of this would be that if you’re very into the fitness community, and maybe you’re even a trainer at a gym, that you only invest in fitness stocks. Yes, you can diversify within that between apparel, nutrition, etc., but this still can really leave you open to a lot of exposure.
You will see this extremely frequently with people’s work. Chances are, you know the industry that you work in better than you know other industries, so this leads you to invest in that industry most frequently.
I think that this is the scariest possible situation because not only are your investments under diversified, but 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 TODAY!
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 in 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? Hmmmm…. Just some food for thought.
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
This bias is really what technical analysts and day-traders use. 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, for its performance and then try to predict where the stock price was going next….it was essentially a very elementary version of what technical analysts do….like 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
Tesla. Uber. Beyond Meat. Any IPO that has come out in 2019. Anytime I talk to my friends they always talk about how they want to find the “next big thing”. Well no crap. Don’t we all want to do 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.
Like I literally have a friend that bought Beyond Meat at $190. So, you waited until the stock had gone up more than 7x its IPO price of $25 and then decided to buy an overpriced stock because you 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. You’re so infatuated with a product or company, and you’re seeing this crazy growth, and all of your friends are talking about it, and it’s always on CNBC (am I describing Bitcoin?), that you now completely forget all of 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 what you believe in, 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.
Like when the market goes down and I blame the trade tariffs, or when the Uber IPO came out and I just kept staring and staring at it before I was like, “Andy, even the executives say the company might actually never make money – so why would you expect to make money investing in that company?”
Be disciplined. Stick to your values and your investing strategy and always, always, always, invest with a margin of safety – emphasis on the safety!