Key Takeaways:
- Psychological biases like confirmation bias, overconfidence, recency bias, anchoring, and herd mentality can cause investors to make emotional rather than rational decisions.
- Asking “What might I be missing?” instead of “What supports my idea?” helps investors counteract confirmation bias.
- A financial advisor can help investors recognize these biases and stay focused on their long-term plan instead of reacting to short-term market swings.
Investors have access to more information than ever before. We can follow markets in real time, read company filings, compare valuations, and hear opinions from analysts around the world. Yet having more information does not necessarily lead to better investment decisions.
Why?
Because investing is not purely a numbers exercise. It is a human exercise.
When markets rise, confidence can lead investors to take on more risk. When markets fall, fear can make a long-term investment suddenly feel like a mistake. A recent success can make us believe we know what comes next, while a recent loss can make us hesitant to invest at all.
These reactions are normal. They are also examples of the psychological biases that can influence investment decisions.
Understanding these biases does not eliminate them. But recognizing them can help investors avoid allowing short-term emotions to derail long-term plans.
Confirmation Bias: Looking for Information That Supports Our Views
An investor may have a particular investment they really like and start sending articles that support their view. They see a positive earnings report and think, “That’s exactly what I was expecting.” Then they come across a negative article and think, “They’re missing the bigger picture.”
That’s confirmation bias, our tendency to give more weight to information that supports what we already believe.
It doesn’t mean that the investor’s idea is wrong. The problem is that looking only for information that confirms our opinion can make it harder to recognize when the facts have changed.
Sometimes the most valuable question isn’t “What supports my investment idea?” but rather: “What might I be missing?”
Overconfidence Bias: “I Saw That Coming”
An investor correctly predicts that the market is going to have a difficult year. They move some money to cash, the market declines, and they feel pretty good about the decision.
A few months later, they correctly anticipate a rebound and invest again before the market moves higher.
After getting a couple of big decisions right, it is easy to start thinking, “Maybe I’m getting pretty good at this.”
That’s overconfidence bias.
The problem is that being right a few times can cause us to overestimate our ability to predict what happens next. An investor may begin making more frequent portfolio changes, taking larger positions, or trying to time the market more aggressively.
Sometimes those decisions will work. But a few successful predictions don’t necessarily mean we’ve developed a reliable forecasting ability.
A good investment decision is not necessarily one that works out. It is one that was made for the right reasons and fits the long term plan.
Recency Bias: “Things Have Been Going Great”
If the market has performed well for several years, it’s easy to become comfortable with strong returns.
An investor might look at their portfolio and say, “We’ve been doing really well. Maybe I should take a little more risk.”
The opposite can happen after a difficult period: “The market has been terrible. Maybe I should just wait until things improve.”
Both reactions can be examples of recency bias, giving too much weight to what has happened recently when thinking about what will happen next.
Recent performance is important, but it shouldn’t determine an investor’s entire outlook.
A strong market doesn’t necessarily mean more strong returns are coming. A weak market doesn’t necessarily mean more declines are ahead.
The long term plan matters more than the most recent chapter of the market.
Anchoring Bias: “I’ll Sell When It Gets Back to What I Paid”
This one is easy to recognize.
An investor buys a stock for $50. It falls to $40.
“I’m not selling it now. I’ll wait until it gets back to $50.”
But why $50?
Because that’s what they paid.
That is anchoring bias, placing too much importance on a particular number when making a decision.
The market doesn’t know what the investor paid for the stock. The more useful question is:
“If I didn’t own this investment today, would I buy it at $40?”
If the answer is yes, there may be a good reason to continue owning it. If the answer is no, waiting for the stock to return to the original purchase price may not be a good enough reason.
The price we paid is part of our investment history. It isn’t necessarily a reflection of what an investment is worth today or what it will be worth tomorrow.
Herd Mentality: “Everyone Else Is Buying It”
It’s difficult to watch something go up without wondering if we’re missing out.
An investor sees a stock mentioned on the news. A friend talks about owning it. They see it all over social media. The stock keeps going up.
Eventually, the question comes:
“Should we be buying this?”
That’s where herd mentality can enter the picture.
We naturally look to others when we’re uncertain. If everyone else seems excited about an investment, it can make the investment feel more attractive.
The same thing happens when markets fall. If everyone around us is worried, selling can suddenly feel like the obvious decision.
The challenge is separating “Everyone else is doing this” from “This makes sense for me.”
An investment can be popular and still not be appropriate for a particular portfolio.
The right investment decision isn’t always the most popular one.
The Bottom Line
None of these biases make us bad investors. They’re simply part of being human.
As we discussed in our article, 10 Reasons to Hire a Financial Advisor, one of the greatest benefits of an advisor is helping you avoid the big mistakes and stay focused on the bigger picture.
Markets will always give us reasons to react. A good advisor helps provide perspective, keep emotions in check, and keep the focus on the long term plan.
If you’d like to have a conversation about your investment plan or how you can avoid some of these common behavioral mistakes, connect with us. We’d be happy to talk.
Clicking on the links above may result in you leaving the Pittenger & Anderson, Inc. website. The opinions and ideas expressed on these external websites are those of third-party vendors and Pittenger & Anderson, Inc. has not approved or endorsed any of this third-party content. For the full Terms & Conditions of using the Pittenger & Anderson, Inc. website, click on this link.
Pittenger & Anderson, Inc. makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
Pittenger & Anderson, Inc. does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. Additionally, the information presented here is not intended to be a recommendation to buy or sell any specific security. To learn more about our firm and investment approach, check out our Form ADV.
To view this article and others like it online, visit the P&A blog at https://pittand.com/blog/.
Click here to download the PDF version of this article.
