Learning from Investor Biases

Behavioral finance is not yet a standardized theory, yet it offers a unique insight into why investors do things that they do. Could it help you avoid booby traps?

You bet! In the 1990s, a new branch of financial economics emerged—behavioral finance, which explored how psychological peculiarities affected the way that certain groups, such as individual investors, analysts or money managers behaved in certain situations.

There is a number of investor biases that typically have negative impact on individual portfolio performances. For example, far too many investors are known to keep the “losers” around for too long, and to get trigger-happy when it comes to “winners,” selling them too soon.

Another investor bias assumes that all growth stocks are “good” stocks by mere nature of having growth potential. As a result, often those same growth rates are overestimated and negative developments ignored.

But perhaps the worst bias is something called the escalation bias. Observation over periods of time identified that investors who feel responsible for creating a failure are highly likely to put more money into that failure rather than into a success.

I have seen that happen far too often during my investment advisor days. Oddly, it was usually a wife that had an idea that didn’t pan out, while the husband all but said, “I told you so!” She would insist on not selling, repeating over and over again that the reasoning behind the idea was still strong. Only, it sounded more like she was trying to convince herself more than anyone else.

How can the effects of investor biases be at least minimized, if not avoided? Simply, for each great tip, investment idea, rumor, what have you, that might come your way, check out all the news, including the bad ones. Also, reevaluate your initial findings frequently. This is a fast paced world we’re trying to fit in!