Unraveling Behavioral Finance Biases: What goes through investors’ thoughts when they buy assets, hold on to stocks, sell stocks, or do other things with their money? You can better understand the stock market and make better investment choices if you know how buyers think.
William F. Spencer is a certified financial planner, head, and wealth planner at Crestwood Advisors. He says, “Behavioral finance studies why investors make choices that are good for them and bad for them.” “It looks at cognitive and emotional biases that help us make sense of the world.”
It’s hard to know what an investor is thinking, but there is a field of finance that studies this. Behavioral finance looks at some of the usual patterns and biases that affect how investors act and, in the end, how their portfolios do.
Unraveling Behavioral Finance Biases: What behavioral finance has to do with the stock market
Investors can use the stock market to gather a lot of information that can help them make smart choices. We have the tools to make smart choices, but most of the time, our feelings decide what we do. Daniel Kahneman, a psychologist who won the Nobel Prize, found that 90% of the time, our feelings affect the choices we make about money.
When you spend emotionally, your fear, ego, greed, or sadness can stop you from making smart choices. Kahneman’s study shows that people who work in finance may think they are immune to financial biases because they are so good at their job.
This subject of behavioral finance helps us notice when we are trading based on our feelings in real time. It’s a way to check your thinking again and take a break before your feelings take over. These are some of the factors that make investors act the way they do:
Anchoring Bias
Anchoring bias is when buyers make decisions based on the first piece of information they come across. “An anchoring bias is likely to cause an investor to choose one asset over another based on the perception that a lower-valued asset appears to be a good deal or opportunity,” says Michael Barbera, a consumer psychologist at the University of North Carolina at Pembroke.
When investors see a stock that looks good, they might not pay attention to other stocks that are priced more attractively. On top of that, they might stick to a negative story even when new information comes in that supports a positive bet. Anchoring bias can also cause investors to hold on to falsely positive stories about the economy for too long, missing signs of a downturn.
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Herd Mentality
Herd thinking uses the power of the crowd to persuade investors to follow the crowd. A lot of buyers jump in without thinking about what started the trend or whether it will last. If a lot of people say something is good, then it must be good. This is called herd thinking.
Investors with this bias might follow the crowd and not pay attention to other points of view. When investors wait to respond to what other people are doing in the market instead of taking the lead, they may lose money. This is called “herd mentality.”
Unraveling Behavioral Finance Biases: Fear of Missing Out, or FOMO
Fear of missing out, or FOMO, is a bias that affects more than just business. It shows up in other parts of our lives too. It’s one of the strongest forces and can cause big losses. It has to do with following the crowd. Herd mindset and FOMO are similar, but according to Barbera, FOMO results from a lack of something.
“In behavioral finance, the fear of missing out is categorized as scarcity,” he says. “Scarcity refers to a cognitive bias that influences decision-making by placing an exaggerated emphasis on the limited availability of a resource rather than its actual intrinsic value. This bias can lead individuals to perceive items or opportunities as more valuable simply because they are scarce or rare, regardless of their true worth.”
Confirmation Bias
Investors often only look for information that backs up what they already think, which is called confirmation bias. One example is an investor who thinks a certain stock will go up in value may only read stories that say the same thing. This investor might not read pieces that explain why the stock is too expensive. Investors can make better choices if they know both sides of an argument, but confirmation bias makes people less likely to look at both sides.
Familiarity Bias
A lot of investors want to stick with businesses and things they know a lot about. This is called familiarity bias. Some investors might only look at tech companies and not stop to check out companies in consumer goods, health care, or other non-tech fields. Investors may not be able to build a varied portfolio and lower their risk as well when they are biased by familiarity. If you want to avoid knowledge bias, index funds can help you by exposing you to more stocks and industries.
Unraveling Behavioral Finance Biases: Loss Aversion
For a lot of investors, the fear of losing money is bigger than the joy of making money. This happens because people don’t like losing money, and Spencer says this is a normal investment bias.
“Loss aversion is natural and affects everyone. People seek pleasure and want to avoid pain,” he says. So it’s common for a 2% drop in account value to make a greater impact on an investor than a 2% gain.
Loss aversion can make buyers miss out on great chances, especially if they are still thinking about losses they have already had. Investors who don’t want to lose money may keep the stock market going high because they think a bear market is about to hit at any time.
Even though a bear market might happen at some point, buyers who are too cautious could miss out on big gains. Sometimes you need to be defensive, but investors don’t act on potential catalysts because they don’t want to lose money.
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Overconfidence
Prices of assets are affected by many things. There are some of these factors that are very clear, while others are not as clear. The market can go in the opposite way for a long time, even when signs point to a bullish or bearish trend.
There are a lot of things that can affect the stock market, but buyers can get too confident after a few good trades. When investors are too sure of themselves, they might think they can guess the stock market, but they can’t because there are too many things that can affect asset prices.
When investors are too sure of themselves, they might put their money into riskier investments because they think they will always make more money than market measures. This plan works until it doesn’t, but keeping making risky bets can fall apart when your overconfidence meets reality.
Unraveling Behavioral Finance Biases: How to Control Your Feelings
Behavioral finance isn’t meant to scare people who are investing. But this area of finance can help investors of all levels stay humble, learn about common mistakes, and make changes to their investments as needed.
Sometimes it’s hard to keep your feelings in check. Barbera gives some ways to reduce FOMO, which can also be used to deal with other investment biases: A good way to deal with FOMO might be to give yourself time. People should make big purchases, investments, or choices when they don’t feel rushed, which means they have plenty of time to make up their minds.
Barbera adds, “The person making the decision should remove themselves from the physical environment where the decision is taking place in order to reflect and place a temporal gap between themselves and the scarcity-influenced decision. This is likely to influence the decision-maker to be more objective in the decision process.”
Instead of rushing into investment chances that need to be made quickly, it can be better to be patient. You have more time to think, which might help you make your choice. It can also help to write down your thoughts on money and think about how your views affect the choices you make.
“Investors can keep their emotions in check by becoming more aware of them. Money is a personal topic that reflects our values. Because of that, it can create a lot of feelings no matter what the situation is,” Spencer explains. “One can pause and notice what is going on for them. Once you have learned how you feel about the money thought, you can decide not to act on unhelpful thoughts and move forward onto helpful ideas.”
