Eliminating all biases when investing is nearly impossible. Financial markets are a prime example of the way human biases can manifest at either end of a spectrum of emotions: this is the core of behavioral finance, where the study of economics and psychology intersect. People don’t always make rational decisions when it comes to money. In fact, they usually do the opposite. However, most of us cannot afford to make mistakes with our retirement money. To secure your retirement, you should avoid these four common investing biases that often lead investors to make mistakes.
1. Hot Hand Fallacy
This is the notion that because one has had a string of success, he or she is more likely to have continued success. For example, one study found that casino gamblers "bet more after winning because they believed that their chance of winning again was greater than before."
This also happens in financial markets as investors make decisions based only upon recent information compared to all of the available data, which can often lead to thinking current trends are the best predictors of what will happen next. According to an Investopedia article on behavioral finance, "Researchers on behavioral finance found that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year. Although financial products often include the disclaimer that 'past performance is not indicative of future results,' retail traders still believe they can predict the future by studying the past."
2. Regret Aversion
Some investors make decisions in a way that allows them to avoid feeling emotional pain in the event of an adverse outcome. This bias motivates people based on two powerful emotions, fear and greed. The theory of regret aversion or anticipated regret proposes that when facing a decision, individuals might anticipate regret and thus incorporate in their choice their desire to eliminate or reduce this possibility.
For example, an investor who fell victim to the dotcom bubble or 2008 financial crisis and sold their equity positions at the absolute worst time would feel anticipated regret if they were to think about re-investing in the stock market again. Thus their bias has caused them to lose out on gains. Regret aversion means people avoid or delay making decisions that might lead to them suffering a loss. The problem is there are lots of financial decisions that could cause regret, but it is not always financially sensible to do nothing. (For related reading, see: Financial Markets: When Fear and Greed Take Over.)
3. Confirmation Bias
Have you ever thought of an investing idea then googled it to find more reasons to believe yourself? That’s confirmation bias. We seek out information to confirm our existing opinions and ignore contrary information that refutes them. This psychological phenomenon occurs when investors filter out potentially useful facts that don’t coincide with their preconceived notions, then suffer as a result. We tend to gather confirming evidence when making investment decisions rather than evaluate all available information.
A quality decision-making process requires an open mind, because evidence tends to cut in multiple directions and understanding all perspectives reduces the chances of error. Thus, if we can eliminate confirmation bias we will have a higher probability of making the best investment decision for our intended objectives. “The stock investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.” ― Benjamin Graham, The Intelligent Investor
4. Hindsight Bias
Hindsight bias occurs when we look at the past and convince ourselves it was more predictable than it really was. “I knew that would happen.” Who hasn’t said or heard that, probably many times? While the know-it-all reminds people of their forecasting prowess, hindsight bias can have detrimental effects on one’s finances or investment strategy. We tend to overestimate the accuracy of our past predictions, which leads to a false sense of security.
This trap can negatively impact our future decisions. Believing we are able to predict future results more accurately can lead to overconfidence. Thus, we begin selecting investments based on "hunches" or "gut reactions" rather then critically evaluating the investment opportunity with data-driven facts and fundamentals. As gut investors, we also buy into stories more than hard data, and many would agree this speculative investing ends up messy.
Protect Your Finances From Your Emotions
Have you experienced any of these biases within your investments? If so, you need to consciously prevent these behavioral biases from creeping into your financial plan. Don't let your emotions get in the way of smart investing and your financial peace of mind.
(For more from this author, see: Volatility and Inverse ETFs: Understand the Risks.)