Oh Behave!
Research in Behavioral Economics highlights the substantial impact of emotions on investment decisions, revealing that investors often commit errors in their thinking processes. Let’s delve into some common investing errors that individuals may unknowingly make due to the influence of emotions on their decision-making…
It’s often said that financial markets are driven by greed and fear—two very powerful emotions. Indeed, during bull markets, investors tend to be greedy, wanting higher and higher prices. Many chase returns, buying at the peak. Then, in a bear market, with prices falling, fear grips them, and they often sell, incurring deep losses.
In short, many investors buy high and sell low. That is the inverse of the mantra for successful investors: to buy low and sell high. Most investors are familiar with this concept, though few practice it in reality because their emotions prompt them to do otherwise.
An entire field of research—behavioural economics—is focused on why people consistently make these poor investment decisions. And researchers have found there are a handful of biases many investors are unaware they have, often driving them to make the same investing errors over and over to the detriment of their money.
An entire field of research—behavioural economics—is focused on why people consistently make these poor investment decisions. And researchers have found there are a handful of biases many investors are unaware they have, often driving them to make the same mistakes over and over to the detriment of their money.
The Anchoring Bias:
We hear about a hot stock tip, and our brains are hardwired to charge ahead without pursuing much more information. This tendency is referred to as an ‘anchoring bias.’ Research in the 1970s by behavioural economics researchers Daniel Kahneman and Amos Tversky demonstrated this bias. In an experiment, individuals had to spin a wheel with numbers on it, and those whose spin landed on a low number typically underestimated an unrelated follow-up question—like how many African nations are in the United Nations? In contrast, those whose spin landed on a higher number often answered with higher estimates. A key problem with anchoring bias is it makes us reluctant to change course with a strategy even when it is evident it’s not working. Most notably, investors often hold onto strong performing stocks too long, and they frequently end up selling only after the share price has fallen significantly from its peak, illustrating one of the common investing errors.
Loss Aversion:
Researchers Kahneman and Tversky—whose body of work in behavioural economics led to a Nobel Prize—also posited that most people have an aversion to losing. That in and of itself isn’t that noteworthy, but with their ‘loss aversion’ theory, what they found is people feel losses more deeply than they experience rewards. As a result, we tend to psychologically value the risk of financial losses more than we value the potential rewards that may come as a result of taking on risk. In turn, individuals often favor low-risk assets like guaranteed investment certificates (GICs) over investing in the stock market, which they view as risky. Indeed, investing in equities is riskier than investing in GICs, but the risk is often worth it because stocks have greater wealth-generating potential over the long term. As a result, these risk-averse investors often miss out on the potential for significantly better investment performance over longer periods, and they end up retiring with less wealth due to their investing errors.
The Sunken Cost Trap:
It’s hard to admit when we’re wrong. Most of us recognize this in each other. But it’s harder to understand the impact of our own wrong decisions and the need to reverse course sooner rather than later. That’s particularly the case with decisions around money. Research from Ohio State University in the 1980s offers insight as to why, explaining that when we make a big investment of time, effort, and money in a decision, we have much more difficulty acknowledging we made a wrong one when it’s indeed evident that it is. Instead of recognizing the error of investing in a bad company, for example, and then selling it sooner than later, we intrinsically hold onto the faint hope that eventually the time, effort, and financial capital will pay off with the stock being profitable. More often than not, however, the losses keep piling up, and we end up losing more money than necessary. But if we can recognize the error, and sell and accept the loss sooner, we can reinvest the money in a better-performing stock likely resulting in a better outcome, preventing further investing errors.
FOMO (The Fear of Missing Out):
It goes by many other names, including ‘following the herd’, ‘herd mentality’, and ‘keeping up with the Jones’. Of all financial biases and errors, fear of missing out—or FOMO—reflects the impact of greed and fear on our investment decisions. Indeed, greed drives us to take risks to pursue investment gains, which undoubtedly can be beneficial. But FOMO is what draws most of us into the greed cycle, fearing that if we do not invest now, we are going to miss out on the profits. Recent research shows the negative impact of FOMO on equity markets time and time again. As well, herd mentality works the other way. When markets fall, negative chatter on social media and elsewhere often leads to a stampede of fearful investors selling at a loss, highlighting the detrimental effects of FOMO on investment outcomes and reinforcing the cycle of investing errors.
Recency Bias:
Similar to anchoring, recency bias reflects how we tend to rely on the most recent event to support our views, while also believing it’s more likely to reoccur in the future. Recency bias often shows up in bull markets, with stocks rising for long spans. Investors often think the bull market will continue indefinitely, while discounting historical evidence that eventually a bear market follows. As a result, many of us are shocked when a sudden, deep drop in stock prices occurs. That often leaves us fearful, and again, recency bias applies. Because our last experience was now negative—seeing our investments fall in price—we often believe these negative conditions will continue. That can lead us to selling those investments at a loss, fearing we will incur steeper losses if we don’t. Then, after that experience, recency bias often prevents us from re-entering markets precisely when we should, when prices are low. And the cycle of behavioural errors continues.
Advisors Can Help:
In the world of investing, we get it – emotions matter. The challenge, however, is that our emotional states can overwhelm rational thinking, and we make these mistakes all the same. But here’s the thing: knowing about these quirks is half the battle. Even when we’re aware, our emotions often cloud our judgment. That’s where Moraine Wealth Advisory steps in. At Moraine Wealth Advisory, we recognize the significance of investor psychology in shaping financial outcomes. Additionally, professional money management can help with advisors—who understand these biases—ensuring we are not becoming our own worst enemies when it comes to investing. Moraine Wealth Advisory’s professional advisors can help you strengthen your investment strategy and protect against the detrimental effects of emotional bias. Take the next step towards informed and resilient investing and meet with us. Let’s secure your financial future together!
