We’ve all been guilty of this in one situation or another – letting our emotions take over and making decisions we would later regret. There’s something inside all of us where – in certain situations – we let emotions and behavioral tendencies take over and put common sense and judgment in the back seat.
In the world of investing, investors often let their emotions and other behavioral tendencies and biases take over their decision-making, just like in other areas of their lives – to the detriment of their portfolios.
Emotion and behavior-based investing is so prevalent that there’s a whole field of psychology dedicated to it – behavioral finance/behavioral investing. There have also been hundreds of books written on the subject.
The Behavioral Investor by Daniel Crosby is one such book with its premise being that “too many investors neglect their process and get overly excited by a stock pick they read about on their favorite financial website, or, probably worse, that they hear about from a friend or someone they respect. They don’t do their full diligence and get lucky or burned. (“You can be right and still be a moron” for making a poorly thought-through decision, according to Crosby.).”
Unfortunately, most investors are behavioral investors who make their investment choices on something other than the numbers and data. Some multiple behavioral biases and tendencies explain why investors invest in non-commonsensical ways.
Here are some of those biases:
Herd Behavior. This bias is probably the most common behavioral investing bias. Herd behavior says investors will make decisions according to what the herd does because they think it’s comfortable or safe. The problem is that the herd has gone over the cliff multiple times over history.
Availability Bias. Availability bias says investors will make decisions based on what’s in their face and their immediate vicinity – social media, the internet, friends, neighbors, colleagues, or anything else clamoring for their attention.
Loss Aversion. Loss aversion lets the fear of losing money rule over anything else. The risk-return tradeoff plays into the loss aversion bias where investors assume that high returns can only come from high risk. The problem with loss aversion is it prevents many investors from considering investments that offer high returns but are not, in fact, high risk.
Status Quo Bias. Investors with status quo bias don’t like change and aren’t open to new investments or opportunities. They stick to what’s familiar or common.
Smart investors are good at blocking noise and suppressing behavioral biases that prevent sound investment decision-making. They stick to data and analytics and listen to other smart and experienced investors.
Are you a behavior investor?
If so, consider following the lead of wealthy investors who have learned to block out their biases and used common sense and judgment in their investing.
