7 Behavioral Biases That May Hurt Your Investments

Do you feel the pain of loss more than the joy of gains? How to separate emotions from investing.

It’s not unusual for investors to sense a tug-of-war between their analytical brains and their emotions.

Until fairly recently, investing was considered purely logical. Find the right quantitative strategy or forecasting model, and you’d be off and running.

But any investor who’s gotten the jitters and pushed the “sell” button at the first sign of a market downturn has acted on emotions.

Often, the emotional response is due, at least in part, to a behavioral bias. For example, perhaps the antsy investor sat out a previous market correction, and now regrets the inaction. Or perhaps he or she just wants to feel in control, and even a panic-driven decision to sell seems better than just sitting back and doing nothing.

These days, asset managers take seriously the behavioral components of investing, and with good reason. Even after working with a financial advisor on an investment policy statement based on risk tolerance and objectives, investors often react in the moment or have trouble shedding long-held beliefs that may hurt their returns.

Cognitive and behavioral researchers have identified a number of common biases that affect investing.

Trent Porter, founder of Denver-based Priority Financial Planning, says investors should become aware of their own biases. “While not inherently bad, and most are natural to human behavior, these biases could negatively impact one’s ability to increase their financial position,” he says.

Here are seven biases that may affect investing performance.

Loss aversion. People often feel the pain of loss more than the joy of gains. Researchers Ori and Rom Brafman, in their 2008 book, “Sway: The Irresistible Pull of Irrational Behavior,” write that athletic teams often play to avoid losing, rather than to win. Sharp-eyed opponents can exploit this timidity with more aggressive play.

Loss aversion takes hold when people recall investment portfolio declines more vividly than gains, sometimes even when the gains are greater. “It upsets people if they lose money when the market goes down. People remember losses forever, but they don’t remember the years they made 30 percent – just years they lost 20 percent,” says Miye Wire, founder of advisory firm MiyeWire LLC, in Reston, Virginia.

Wire recommends that investors have discussions with their advisors about market expectations and managing emotions during downturns. “Memories are short,” she says.

Confirmation bias. People are often drawn to information or ideas that validate existing beliefs and opinions. For example, many TV viewers prefer a news channel that represents their own political views, avoiding those featuring commentators of different opinions.

People do the same when it comes to financial topics. An investor may have a belief about market conditions and gravitate toward information sources that confirm that belief.

“Oftentimes, it happens when we attach an emphasis to the outcomes we desire, such as investing too much in the stock of the company you work for, which also reduces your diversification. The best way to overcome this bias is to consider information from multiple sources,” Porter says.

Mental accounting. First identified by behavioral economist Richard Thaler of the University of Chicago, mental accounting occurs when a person views various sources of money as being different from others.

Mental accounting can manifest itself in a few ways. Money earned at a job may be viewed differently than money from an inheritance. This can affect the way the money is spent or invested.

In a 1999 paper on the topic of mental accounting, Thaler cited an example of a trip he took to Switzerland to give a talk. Afterward, he and his wife took a vacation in the area. “At that time the Swiss franc was at an all-time high relative to the U.S. dollar, so the usual high prices in Switzerland were astronomical. My wife and I comforted ourselves that I had received a fee for the talk that would easily cover the outrageous prices for hotels and meals. Had I received the same fee a week earlier for a talk in New York though, the vacation would have been much less enjoyable,” he wrote.

Mental accounting shows up in investor portfolios, too. “People get emotionally tied to certain stocks,” Wire says. She recalls a particular elderly woman who wouldn’t part with a large holding of stock in a local bank started by a family member. Wire says it’s a fairly common problem.

“Especially if it’s something they inherited or was a gift, or it’s a company they used to work for, people can become emotionally involved with owning certain stocks. When people have employee stock purchase plans to buy company stock, they feel like they’re more loyal employees if they own it, even if it’s a bad investment and they’re not diversified,” Wire says.

Illusion of control bias. After a prominent plane or train crash, it’s not hard to find online commenters proclaiming a preference for travel by car, saying they feel more in control when driving. Many are resolute in this preference despite decades of research showing that air and rail are statistically much safer.

A similar thought process applies to some people’s investing decisions. “The illusion of control begins with the word ‘should,’ as in, 'I should be able to pick the right stocks,' or 'someone should have the ability to time the market to achieve superior results consistently,'” says Michael Kay, president and advisor at Financial Life Focus in Livingston, New Jersey.

People can easily justify those ideas, he says, but that thought process can be financially damaging. “People who live under this belief have trouble coming to terms with the irrationality and variability of markets and the impossibility of their expectation. The outcome is typically a spiral of financial disaster and the rationalization that while their belief is correct, the person who pushes the buttons wasn't competent,” Kay says.

Recency bias. When gas prices fall, sales of large sport-utility vehicles and trucks tend to rise. It’s not difficult to see the connection: Consumers believe what’s happened recently will continue to happen.

The phenomenon also exists with investing. It’s no secret that retail investors tend to chase investment performance, often piling into an asset class just as it is peaking and about to reverse lower. Because the investment has been climbing higher recently, investors believe that will remain the case.

Unfortunately, research has shown that it’s essentially impossible to predict which asset class, sector or geographic region will be the top performer in any given year. But past performance can be a strong driver, as few people want to feel left behind.

Wire says interest in gold, which took a sharp turn lower in late 2012, was an example of investors’ recency bias before the yellow metal plummeted. “For three years, everybody wanted to buy gold. I just kept saying, ‘Really?’” she recalls.

Hindsight bias. “I knew that would happen.” Who hasn’t said or heard that, probably many times?

While the know-it-all who reminds people of his or her forecasting prowess can be annoying, hindsight bias can have detrimental effects on one’s finances.

“Humans tend to overestimate the accuracy of their predictions. This can be costly as we get a false sense security when making investment decisions, which can lead to excessive risk-taking behavior and place people’s portfolios at risk,” Porter says.

Herd mentality. Rugged individualists aside, people are social animals. Marketers know this, and have become adept at creating social proof that since other buyers like their products, so should you. It’s another type of thought process that takes hold when a person doesn’t want to be left out of a trend or a movement.

That’s very true when it comes to investing. Just because the larger herd is stampeding into or out of a stock, sector or region, it doesn’t mean that’s the right move for an investor with his or her own objectives.

“Investors that buy when the market is high and sell when the market is down are more than likely influenced by the herd mentality,” Porter says. “This bias occurs when individuals are influenced by their peers to follow trends, purchase items and adopt certain behaviors, even if it is not in their best interest. It is important to stop and ask yourself why you are making this financial decision, and looking to see if it aligns with your financial plan. Doing so will go a long way in helping ensure that the actions you are taking are actually right for you, not for someone else.”