Proponents of efficient markets believe that all known information is already priced into a stock or other investment. The rise of algorithmic trading has made that information processing in market prices almost instant, according to efficient market theorists.
However, others remain unconvinced. They argue that the reason long-term investors like Warren Buffett or high-frequency traders can consistently earn profits is because of market inefficiencies. These inefficiencies, they claim, are inevitable because markets are comprised of humans or computers that are programmed by human beings.
Regardless of how disciplined, people often make financial decisions that are colored by behavioral biases that cause them to act on emotion or make mistakes processing information. This is the basis for behavioral finance, a field of study that combines psychological theory with conventional financial economics. Behavioral finance predicts actual trading behavior based on these factors and is used as grounds for crafting more efficient trading strategies that correct for human limitations.
Here, we highlight four prominent behavioral biases that have been identified as common among retail traders who trade within their individual brokerage accounts. In particular, we look at overconfidence, regret, attention deficits, and trend-chasing.
- Behavioral finance has revealed that real people do not behave like the rational actors predicted by mainstream theories and the efficient markets hypothesis.
- Real traders and investors tend to suffer from overconfidence, regret, attention deficits, and trend-chasing—each of which can lead to suboptimal decisions and eat away at returns.
- Here, we describe these four behavioral biases and provide some practical advice for how to avoid making these mistakes.
Overconfidence has two components: overconfidence in the quality of your information, and your ability to act on said information at the right time for maximum gain. Studies show that overconfident traders trade more frequently and fail to appropriately diversify their portfolios.
One study analyzed trades from 10,000 clients at a certain discount brokerage firm. The study wanted to ascertain if frequent trading led to higher returns. After backing out tax-loss trades and others to meet liquidity needs, the study found that the purchased stocks underperformed the sold stocks by 5% over one year and 8.6% over two years. In other words, the more active the retail investor, the less money they make.
This study was repeated numerous times in multiple markets and the results were always the same. The authors concluded that traders are, "basically paying fees to lose money."
How to Avoid This Bias
Trade less and invest more. Understand that by entering into trading activities you're trading against computers, institutional investors, and others around the world with better data and more experience than you. The odds are overwhelmingly in their favor. By increasing your time frame, mirroring indexes, and taking advantage of dividends, you will likely build wealth over time. Resist the urge to believe that your information and intuition are better than others in the market.
Admit it, you've done this at least once. You were confident that a certain stock was value-priced and had very little downside potential. You put the trade on but it slowly worked against you. Still feeling like you were right, you didn't sell when the loss was small. You let it go because no loss is a loss as long as you don't sell the position. It continued to go against you but you didn't sell until the stock lost a majority of its value.
Behavioral economists call it to regret. As humans, we try to avoid the feeling of regret as much as possible, and often we will go to great lengths, sometimes illogical lengths, to avoid having to own the feeling of regret. By not selling the position and locking in a loss, a trader does not have to deal with regret. Research shows that traders were 1.5 to 2 times more likely to sell a winning position too early and a losing position too late, all to avoid the regret of losing gains or losing the original cost basis.
How to Avoid This Bias
Set trading rules that never change. For example, if a stock trade loses 7% of its value, exit the position. If the stock rises above a certain level, set a trailing stop that will lock in gains if the trade loses a certain amount of gains. Make these levels unbreakable rules and don't trade on emotion.
3. Limited Attention Span
There are thousands of stocks to choose from but the individual investor has neither the time nor the desire to research each. Humans are constrained by what economist and psychologist Herbert Simon called, "bounded rationality." This theory states that a human will make decisions based on the limited knowledge they can accumulate. Instead of making the most efficient decision, they'll make the most satisfactory decision.
Because of these limitations, investors tend to consider only stocks that come to their attention through websites, financial media, friends, and family, or other sources outside of their own research. For example, if a certain biotech stock gains FDA approval for a blockbuster drug, the move to the upside could be magnified because the reported news catches the eye of investors. Smaller news about the same stock may cause a very little market reaction because it doesn't reach the media.
How to Avoid This Bias
Recognize that the media has an effect on your trading activities. Learning to research and evaluate stocks that are both well-known and "off the beaten path" might reveal lucrative trades that you would have never found if you waited for them to come to you. Don't let media noise impact your decisions. Instead, use the media as one data point among many.
4. Chasing Trends
This is arguably the strongest trading bias. 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.
Humans have an extraordinary talent for detecting patterns and when they find them, they believe in their validity. When they find a pattern, they act on it but often that pattern is already priced in. Even if a pattern is found, the market is far more random than most traders care to admit. The University of California study found that investors who weighted their decisions on past performance were often the poorest performing when compared to others.
How to Avoid This Bias
If you identify a trend, it's likely that the market identified and exploited it long before you. You run the risk of buying at the highs - a trade put on just in time to watch the stock retreat in value. If you want to exploit an inefficiency, take the Warren Buffett approach; buy when others are fearful and sell when they're confident. Following the herd rarely produces large-scale gains.
Frequently Asked Questions
What Is Regret Aversion?
Regret aversion is when a person wastes time, energy, or money in order to avoid feeling regret over an initial decision that can exceed the value of the investment. One example is buying a bad car, then spending more money on repairs than the original cost of the car, rather than admit that a mistake was made and that you should have just bought a different car.
Investors do the same by not making trades, or else holding on to losers for too long for fear of regret. Having a basic understanding of behavioral finance, developing a strong portfolio plan, and understanding your risk tolerance and reasons for it can limit the probability of engaging in destructive regret avoidance behavior.
How Can I Tell If I Am Overconfident?
If you are asking this question, you may already be subject to overconfidence. Feeling that you know more than others or than you actually do is a crucial mistake made by novices to experts alike. As part of human nature, it is safe to assume that you may be exhibiting overconfidence in some aspect of decision-making.
What Can I Do to Avoid Chasing Trends?
Herding behavior and market psychology are difficult to detach from as human beings. A good way to stay clear of trend-chasing is to create an objective and unbiased strategy and then stick with it no matter what. Set your exit criteria ahead of time and do not deviate. Passive indexing or contrarian strategies can also be used to avoid this bias.
The Bottom Line
Do you see a bit of yourself in any of these biases? If you do, understand that the best way to avoid the pitfalls of human emotion is to have trading rules. Those might include selling if a stock drops a certain percentage, not buying a stock after it rises a certain percentage, and not selling a position until a certain amount of time has elapsed. You can't avoid all behavioral bias but you can minimize the effect on your trading activities.