Understanding and Managing Behavioral Biases Leads to Higher Returns

By Jane Young, CFP, EA

We strive to invest our money in a logical, consistent, and rational manner but we have deeply ingrained biases that influence our decision making.  We have cognitive and emotional biases that result in irrational decisions and lower investment results.  Successful investors strive to recognize and overcome their psychological biases which result in lower risk and higher returns.  As Benjamin Graham once said, “The investor’s chief problem – and even his worst enemy – is likely to be himself”.  Below we will explore some behavioral biases that can have the greatest impact on your investment success.

Loss aversion is when investors strongly prefer avoiding a loss to achieving a gain.  Studies have found that people commonly weigh a loss more than twice as heavily as a potential gain.  For example, the chance of losing $1,000 must be offset with the chance of earning $2,000, a proportional return is not enough to take the risk.  

Loss aversion manifests itself in two very different ways.   The first is the tendency to lock in losses after a sharp drop in the market, this prevents any chance of recovering when the market rebounds.  This behavior is driven by a strong fear of loss rather than a rational analysis of fundamentals and long-term market performance.  The second is the tendency to hold on to losing stocks in the hope they will rebound.  This comes from a reticence to lock in the loss.  This bias results in holding losing stocks too long and selling rising stocks too soon.  

Recency bias can also be harmful to your portfolio by placing too much emphasis on current events.  There is a tendency to assume current trends will continue even when they are out of the ordinary.  This may cause investors to sell at a loss when conditions seem unusually bad.  It may feel like this time is different, but it rarely is. It just feels worse while you are experiencing it.  Recency bias can also cause investors to invest too heavily in hot asset classes, assuming the trend will continue.  This is rarely the case as we learned from the dramatic drop in technology stocks in 2000.  

Overconfidence is an emotional bias that leads us to believe we have more control than we actually do. With such a large amount of data available on the internet, investors can easily over-estimate their ability to predict the market.  Market performance involves the complex interaction of countless variables which is impossible to predict.  Overconfident investors commonly, underestimate risks and over- estimate returns. They often also engage in market timing, excessive trading, and premature selling all of which generally lead to underperformance.

To overcome behavioral biases, focus on long-term market trends and your financial goals.  Establish an asset allocation consistent with your emotional risk tolerance.  Create and maintain a diversified portfolio.   Stick to your plan and avoid reactions to short-term market fluctuations.