Behavioral Finance: Your Own Worst Enemy

Behavioral topics in investing have gained popularity over the last several years as an alternative to traditional theories. The old way of thinking held that all investors made decisions rationally, looking for the best risk and reward tradeoff for their needs. Hindsight is usually the best evidence that this isn’t always the case and investors can let a wide range of biases cloud their judgment.

You might not always be able to avoid letting your emotions interfere with sound investing, but understanding how they play a part is a good step to meeting your goals.

Don’t get in the way of making money

The decision to invest in a company should be based solely on valuation metrics or some other analysis of future returns. Behavioral finance acknowledges that investors often let emotions, stereotypes, and irrationality influence their judgment.

Whole textbooks are written on the subject of behavioral finance and investing biases, way more than we can cover in one post. A good start is understanding some of the most common biases that plague investor behavior.

Overconfidence is the irrational belief in one’s ability to predict market or stock movements. As an investor spends more time investing and learning how to invest, they become more susceptible to overconfidence and believe they can beat the market and other investors. It can lead to buying and selling frequently which causes costs and taxes to increase.

Anchoring refers to the inability to fully use new information about a stock once an investor has taken an opinion or bought shares. Investors get “anchored” in their views and disregard all new or contrary information. The failure to use new information or change a view could lead to surprises when the new information is fully reflected in the stock price such as when sales or profits show that the new information was material on the company’s business.

Loss aversion is the tendency to hold on to losing investments longer than is appropriate in the hopes of a recovery. The investor commits to holding the stock even after new information points to a change in the long-term value of the shares. Even worse, the bias can lead to taking higher risks just to, “get back to even.”

Familiarity is the preference investors give to stocks or companies with which they have some association. A lot of investors hold too much of their portfolio in the stock issued by their employer or in companies based in their hometown. Being close to the company gives investors a false sense of security and their portfolio becomes overweight in risks to those companies. Investing in one’s employer is especially risky as a loss in corporate profitability will not only mean a loss in investments but possibly a loss in income as well.

Avoiding behavioral biases

The most effective way of avoiding behavioral problems in investing is to have a written and organized method for analyzing and investing in stocks. Writing down how you will analyze companies and the criteria you will use for buying or selling gives helps to keep your investing disciplined. Or, if you know you can’t, make use of a Robo advisor like Wealthfront.

Sticking to a plan on how you will analyze stocks will help to mitigate loss aversion and familiarity. I make it a point to reevaluate any stock that loses more than 5% in less than a month. Was the drop because of the general market or something related to the company? Does the new information reduce the long-term competitiveness of the company? Writing down the reasons for buying shares when you make the initial purchase will help to analyze a stock when new information comes out. Having a formal checklist for analysis will also help avoid buying companies simply on familiarity.

Overconfidence and anchoring are best confronted with actively seeking opinions different than your own. Make sure you regularly read analysis or insight that proposes a different view from your own and seriously consider the points being made.

We are all prone to investing based on our own experiences and personality. This can be a benefit just as well as a disadvantage. We all have different needs and goals so our portfolios are going to be constructed differently. Just remember that we are wired with various irrational imperfections and be aware that these show up in our investing style. Understanding the various biases will go a long way to avoiding them or at least minimizing them.