The Psychology of Investing: Overcoming Common Behavioral Biases

Brains are important in investing. To excel in financial markets, you need to understand basic mathematics, how financial statements work, and the intricacies of business models.

But what if I told you there was something 10x more important than pure smarts to succeed as an investor: your emotions. Managing your psychological state and the biases we all trap ourselves in can help you take your investing skills to the next level. And yet, few people focus on them.

A robot stacking blocks that spell "BIAS"

Take this quote from the late great Charlie Munger, one of the best investors of the last 100 years:

“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success.”

You don’t need a high IQ to succeed as an investor (although it is obviously a plus). But you do need high emotional intelligence. Therefore, it is important to learn about psychological biases to avoid investors’ common pitfalls.

In this post, you will learn the five most important behavioral biases for investors:

Let’s get to it.

The Disposition Effect

First up is a cognitive bias that affects everyone. I have repeatedly felt this effect, and I bet you have as well. It is the Disposition Effect, which simply means you tend to sell a financial asset that has appreciated and want to hold or double down on financial assets that have gone down in price.

As humans, our instincts are to despise taking losses. But in financial markets, this can hurt our returns. Stocks typically go up because the underlying business is doing well. They go down because of the opposite. Just because a stock is down 50% doesn’t make it cheap, and just because a stock is up 100% doesn’t make it expensive.

There is unlimited upside for a winning investment. The best stock in your portfolio may go up 100x, which can make up for a lot of poor investments. But if you sell a stock after it pops 20% due to the bias of the Disposition Effect, you are preventing yourself from seeing that 100x upside.

a stock chart going up

You can only lose 100% of the money you put into an investment, as long as you don’t double down or use leverage. But you can make 10,000% on a winning investment that you hold on to for the long term.

This difference is why top investors like Peter Lynch and David Gardner repeat the adage, “Don’t trim the flowers and water the weeds.” These legends understand that gains are made by holding onto huge winners, but we are biased to want to hold the stocks that have gone down to prevent the locking in of financial losses.

Let your winners run, and don’t double down on a losing investment. Your portfolio will thank you a few decades from now.

Bias For Action

Our second bias is self-explanatory. Action Bias states that humans prefer to do something instead of nothing. We like action. We have a tough time being patient, sitting on our hands, and keeping the status quo. Most people can’t even meditate in silence for 10 minutes.

I think you can understand how this materializes in investing.

When the stock market is open, you can buy or sell any stock anytime. Prices update constantly; with this flood of stimulation, investors get incentivized to get in on the action (see what I did there?).

Most investors trade too much. They constantly switch positions, sell small winners, and trim their portfolios. There is a belief that continuous action will help optimize the portfolio. When you do something, there has to be some benefit, right?


There is a third decision you make with your stocks every day. This is the decision to hold your investments, and it should have just as much meaning in your mind as buying and selling.

The best investments Warren Buffett has made—American Express and Coca-Cola come to mind—were bought decades ago. Since then, he has sat on his hands and hasn’t touched either position by buying or selling more. He has simply held the stocks. This is through times of overvaluation (Coca-Cola in the late 90s) and undervaluation when a more manic trader might be buying and selling the positions.

Buffett’s inactivity may seem like he is being lazy or not properly optimizing his portfolio to achieve the highest returns. But this is the Action Bias at play. He makes a decision to hold these positions every day, even though he is not taking any action.

We instinctually prefer action over inaction because it feels like taking action will improve our results, when in fact the opposite could be true.

Anchor Bias

We are all instinctually biased to the first price we are presented with on a stock. Sometimes, we are biased to prices presented to us in the past. This is known as Anchor Bias.

For stocks, we tend to anchor to the price we saw when we first bought the stock or when we first started following the company. I can’t tell you how many people tell me a stock is “cheap” because it is down 90% from all-time highs. They are simply referencing the higher stock price and have no bearing on whether the stock was overvalued in the past or if the business fundamentals have materially changed today.

The Anchor Bias makes investors believe an equivalent stock is cheap because it used to trade at a much higher price. Conversely, it irrationally makes investors believe a stock is expensive because it is at all-time highs.

a person with a magnifying glass over a stock chart arrow with wood blocks spelling PRICE

This prevents investors from buying long-term winners like Costco and Amazon and biases them to look at losing stocks like Bed Bath and Beyond or other failing legacy retail operators.

Just because a stock trades at all-time highs doesn’t mean it is expensive. In fact, as we discussed in the above section, a stock typically soars to all-time highs because its underlying business is doing well. This is a good thing. It should indicate something special about this business worth investigating further.

Don’t let the Anchor Bias keep you from investing in winning stocks just because they are higher than they were in the past.

The Endowment Effect

I love thinking through this next cognitive bias. Once you learn about it, you can see it constantly affecting people’s decisions, including investors. The Endowment Effect states that people are biased to favor things simply because they already own them.

It is present in stock investing. Investors bias the stocks they own in their portfolios over others, preventing you from thinking clearly about your asset allocation.

The fact you own a stock changes nothing about its underlying business. It will generate the same profits whether you own 0 shares or 1,000. To fight this bias, you need to treat stocks you own and don’t own with equal scrutiny.

a person using a balance/scale

The best way to do this is to force rank your existing holdings and stocks on your watchlist regularly. You will be surprised at how often a stock you own falls below a stock you have on the watchlist simply because you have “liked” the one you own for a long time. This should be an indicator that you may want to make a change to your portfolio.

Don’t be afraid to break up with your stocks because you have been with them long. Don’t let the Endowment Effect hurt your investment returns.

Survivorship Bias

My last bias is perhaps the most devious. Investing commentators constantly use it to try to influence you to buy a stock. Of course, this is Survivorship Bias, when you only consider the surviving set of an original group that was much larger to begin with.

The best way to explain this bias is with an example. Let’s say you read the history of Amazon. You saw that the company lost money – at least on a GAAP accounting basis – for around two decades and turned into one of the best-performing stocks ever.

a person with an amazon box

Taking this information in a vacuum, you might form the assumption that money-losing companies with fast revenue growth are the secret to market-beating returns. But that couldn’t be further from the truth. Amazon is the exception to the rule of unprofitable businesses.

It is one of the few companies that lost money for prolonged periods that “survived” to the present day. Dozens of others have gone bankrupt and seen their stock prices fall over 90%.

Whenever you see someone say “This company attributes the traits of [X successful stock]” and claims that it is therefore a buy, you should be skeptical. Just because one stock has done well with similar characteristics doesn’t mean all stocks with these characteristics succeed.

This bias has lost investors tons of money in recent years by chasing fast-growing money-losing stocks. Understanding the Survivorship Bias can keep you grounded and thinking independently when looking at a stock.

Brett Schafer

Brett Schafer is an investor, host of the Chit Chat Stocks Podcast, and writer at the Motley Fool.

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