What’s one of the biggest, and most common, mistakes we see from investors and people managing their own portfolios?
The tendency to make important decisions quickly, based on little more than a feeling (typically one based in fear).
For example, have you ever caught yourself rushing to sell a certain stock as soon as its value starts dropping?
If you have, you’re not alone.
There’s a name for what it is that makes people act this way: behavioral investing.
And it’s hard on your sanity as well as your returns.
This article will walk you through everything you need to know to avoid the major behavioral investing pitfalls, including:
- Knowledge about the biases, shortcuts, fallacies, and other things that trip up investors.
- Tools and tactics for overcoming behavioral investing hazards and improving portfolio management.
What Are Behavioral Finance & Behavioral Investing?
Behavioral finance is the study of how human psychology impacts behavior when it comes to investing and financial management — and how that behavior in turn affects markets.
This subset of behavioral economics looks at the role emotions and biases play in financial decisions, market inefficiency, mispricing, and so on.
Behavioral finance hinges on the belief that individual investors and professional investors both aren’t 100% rational. They’re human beings, which means they’re fallible, can have biases, don’t always have perfect self-control, and make the wrong decisions sometimes.
Behavioral investing is what economists call it when an investor acts irrationally based on their feelings, biases, and other elements that behavioral finance studies.
15 Biggest Pitfalls of Behavioral Investing
Up next: the biggest pitfalls that trip up investors and money managers.
Why are these so important to study?
Because the nature of many of these biases, assumptions, and everything else is that they’re practically invisible until the moment you know about them.
When you understand that perhaps some of your decisions are swayed by lifelong biases you didn’t even know you had, you will be better prepared to avoid knee-jerk actions and make more informed, wiser determinations.
2 Heuristic Assumptions
Heuristics are, basically, shortcuts. Often in the financial world, we call these rules of thumb.
They’re used because they offer a quick model for decision making, which is helpful when you’re in a time crunch. The problem arises when we rely on them as fact, instead of the assumptions that they truly are.
Here are some heuristics we see applied without question in the investing world, which doesn’t always end well.
Past Performance = Future Performance
One heuristic that is wildly popular is the assumption that the way an investment has performed previously impacts how it’s going to perform in the future.
Of course, there is some value in knowing the history of an asset. But, this assumption can cause investors to ignore impactful outside factors — economic fluctuations, asset management changes, fund management shifts, etc.
All Sales Are a Good Deal
How often have you fallen for a discount just to learn that what you paid is close to full price — it was just marked up to make the deal look sweeter?
As humans, we tend to trust that a sale price is always a good price, because it’s below the full price on the tag. This is because of a heuristic belief in reference points that are reported with authority. In this case, the referent point is the full price. Since we trust that reference point and the sale price is below it, we automatically assume that we’re getting a good deal.
It’s easy to see how this heuristic can cause you to spend money you might not have intended to spend, and also spend more than you should on an asset because it’s a “deal.”
Cognitive biases are inclinations toward or against certain ideas, objects, and even people.
While we often talk about biases as being innate, they’re actually judgements learned during our upbringing and can be impacted by our surroundings throughout our lives. Many biases are unconscious.
Familiarity bias causes us to stick to things we know and understand because they feel safe.
For investors, this leads to buying similar assets from similar companies and similar locations over and over again. This is harmful to portfolio diversification efforts, which require taking on investments from uncorrelated sectors to ride out volatility.
Experiential Bias (or Recency Bias)
Experiential, recency, or sometimes “availability” bias leads people to believe that something that happened recently is very likely to occur again.
A potent example is the Great Recession that rocked the world in 2008. Many investors who lived through it were so sure it was going to happen again that they avoided buying stocks for much longer than necessary — which only continued to depress financial markets.
As we know now, the same thing did not happen again and Wall Street has made a full recovery.
Confirmation bias leads people to seek out and/or trust information that supports a belief they already hold.
We see this bias in all parts of life, including investing. The downside of this bias is that it can lead investors to act on information about a certain asset just because it aligns with their opinion — even if it isn’t true.
Self-attribution is all about believing that great returns are a result of your unmatched knowledge or skill.
We love to see investor confidence! However, there is a dark side to this bias — the belief that poor returns are simply bad luck.
This bias causes a case of overconfidence that can lead to some really disastrous investment decisions if it goes unchecked.
Similar to the above, hindsight bias is the tendency to say “I always knew it!” when looking back at asset performance.
This misconception can lead investors to believe they have some kind of unique insight, which again can lead to ill-informed and expensive investment mistakes.
In representative bias, assets or financial events that just happen to have similar features are linked together, even if they have nothing to do with each other. This can cause investors to think that the behavior of one will be similar to the behavior of another, which usually turns out to be untrue.
Framing bias may have an impact on the heuristic trust in reference points that we discussed earlier.
With framing bias, the way that data is presented — or “framed” — has a major impact on decision making. This is dangerous because what’s actually important is what the data itself has to say.
A smart salesperson knows all about framing, so be sure you know the actual facts before buying into an investment that sounds too good to be true.
People like to run with the first piece of information they learn, even if it’s wholeheartedly wrong. This is known as anchoring bias.
Anchoring bias is just as dangerous in the financial world as it is anywhere else, because even if the first market price or piece of research you see about an asset is wrong — it may still have an outsized impact on your final decision.
5 More Fallacies, Behaviors, and Other Downfalls
For the cherry on top, here are a few more behavioral investing odds and ends that the study of behavioral finance has uncovered.
Emotional reasoning is what we call it when we are aware of our biases and heuristics — and think they’re actually tools for rational, science-based decision making!
As we explained, biases and heuristics are built on emotions and social influence, not fact. It’s important to be aware of this if you're going to rely on them for any kind of decision making.
We talk about avoiding and reducing risk a lot in the investment world. That’s because it’s more likely for investors to be risk averse than to be risk tolerant.
This is why loss aversion is so rampant in the financial realm. With loss aversion, investors feel more impacted by losses than by gains — even if the amount of each is equal. In other words, we tend to feel a yearly loss of $5K more than we do a gain of $5K.
This tendency can cause inventors to forgo some really great opportunities out of perceived danger.
Herd behavior is exactly what you think — the human desire to side with the majority.
In finance, this is what causes rallies and sell-offs as investors all mimic each others’ behavior. This may be one of the most obvious ways behavioral investing influences stock market movement and pricing.
The Narrative Fallacy
Another thing we have a fondness for as humans? A good story.
Our need for a narrative may draw us to put our funds into the most interesting assets, even when they don’t promise as desirable an outcome.
The impulse to invest in assets with a robust story behind them can lead investors to filling their portfolios with expensive stocks, instead of leveraging more “boring” strategies like dollar cost averaging or becoming a value investor.
When investors do mental accounting, they assign specific jobs to their money, often depending on where it came from. This goes against the concept of money being ultimately fungible — or interchangeable.
Mental accounting is what makes it “easier” to spend credit versus cash, and why we pull money from our checking accounts instead of our savings accounts even though they’re equally accessible.
Applying money to specific goals isn’t a bad thing, but it can go too far when saving “special money” gets in the way of paying off debt or investing in low-risk assets that have the potential to create a nice investment return over time.
5 Tactics and Tools for Overcoming Behavioral Investing Hazards
Knowing the behavioral biases and fallacies that may lead you astray is half the battle.
The other element you need to win the war against behavior-based decision making?
Tactics and tools that challenge the status quo.
Get a Data-Backed Understanding of Your Portfolio Using Kubera
Financial data is one of the greatest tools we have to aid our investment strategies in this day and age.
A platform for organizing and understanding all that financial data is equally important.
Kubera is cutting-edge personal balance sheet software that provides a high-level (as well as granular) overview of your investment portfolio performance so you can manage finances based on facts — not emotions and biases.
To get started with Kubera, all you need to do is sign up and start connecting your financial accounts. See some of the thousands of financial institutions with which we integrate here.
First, use Kubera’s smart platform to monitor account-based assets like banking and savings accounts, brokerage profiles, cryptocurrency dashboards, and more. We’ll reflect account developments in real-time.
If it’s in your portfolio, Kubera can help you track it.
Of course, it doesn’t stop at just tracking your assets.
Kubera also empowers you to understand investment returns with our IRR for investments calculator.
Using information like value, price, cash flow, and holding time, Kubera automatically finds internal rate of return (IRR) — a more robust form of ROI.
This IRR number is displayed in your preferred currency and benchmarked against popular indices. This extra info is absolutely pivotal in understanding portfolio performance on a grand scale — so you can make informed decisions around what and when to hold and sell.
Check out this help center article to see our IRR estimator in action.
Next, hop over to Kubera’s Recap screen in your dashboard to get an easy-to-digest view of net worth and asset value changes over time.
From daily breakdowns to yearly summaries, Kubera provides a deep, data-backed overview of performance — providing that historical data that you need to make informed forecasts about your portfolio.
See these features and more in action from our how Kubera works page.
Take Your Time
We’ve learned today that the first piece of information you get isn’t always the best, data that aligns with your thinking could still be flawed, and the crowd isn’t always right.
How can you overcome the desire to give into all the biases and assumptions that power knee-jerk reactions?
In addition to gaining a bird’s-eye view, it’s all about slowing down.
Take your time to carefully research assets. Ask around to grow your knowledge. Give yourself a few days to make an investment decision.
When you take the time to study an option from various viewpoints and see what others have to say, you’re more equipped to spot where your biases and assumptions are creeping in and squash the ones that will lead to illogical resolutions.
As the saying goes, only fools rush in.
Commit to Rules and Systems
In the heat of the moment, it can be beyond difficult to overcome loss aversion, the desire to follow the herd, and other biases to make the most logical decision.
That’s why it’s best to put rules and an investment process in place before you need them.
This means creating a strict investment policy of sorts, which outlines things like:
- Desired asset allocation
- Risk tolerance
- Financial objectives
- Rules for making purchases
- Rules for making sales
Focusing on this process gives you the power to think methodically and make decisions that (mostly) rule out emotion and outside influence.
Become a Contrarian
Speaking of sticking to a system, one that has worked for a long time is known as “contrarian investing.”
And it’s just what it sounds like — a commitment to investing when and where others are scared to.
There are several famous quotes throughout history that sum up this strategy:
Nathan Rothschild of the Rothschild banking family is thought to have said "The time to buy is when there's blood in the streets.”
And then there’s Warren Buffett’s advice to "Be fearful when others are greedy, and greedy when others are fearful.”
What are they getting at?
A successful contrarian strategy requires investors to buy and sell assets that contrast with current market sentiment. That means doing things like purchasing stock in unpopular industries, or investing in new companies that don’t have a strong record of returns (yet).
However contrarian your strategy, it should still be well informed. When you’re going against the grain, it’s especially important to do your research and confirm that the prevailing sentiment is indeed wrong and that there is opportunity in the unpopular decision you’re about to make.
Lean Into Biases — Look at the Downside
Loss aversion shows us that we have a proclivity for focusing on the downside. So, why not lean into that?
To create successful investment management strategies and goals, accentuate the worst case scenario.
You might just find that gloomy phrasing like “I’m investing in this asset now so that I don’t have to work after retirement age.” is more impactful for you than saying something sunny, like “I’m creating a better future for myself!”
Break Through Biased Behavior With Kubera’s Data Dashboard
Once you’re aware of your biases, long-held assumptions, outside influences, and other behavioral investing downfalls — they become a lot easier to avoid.
Layer onto that tactics like creating steadfast rules, taking your time to get informed, and adopting a personal balance sheet dashboard and you’ll be all set for smart investing.
Kick off your journey to moving past behavioral investing when you sign up for Kubera.