5 Emotional Investment Biases To Avoid
Investing based on emotions rarely leads to success in the markets. In this article, we will explore 5 emotional investment biases that can lead to poor decision making when investing.
1. Loss-aversion bias
Loss-aversion arises when investors feel more pain from a loss than pleasure from an equal gain. If Alice lost 10 percent on a bad trade, it would crush her emotionally. But if she made 10 percent on a good trade, she would only be mildly happy.
Investors like Alice will try to avoid losses at all costs. This can lead to the following poor investment decisions:
- Holding bad investments for too long to avoid realizing a loss.
- Not letting ‘winners run’ but instead banking small profits to avoid small losses.
- ‘Doubling down’ on poor investments that are already losing money.
- Taking excessive risk with money they already made from trading, but taking much less risk with the rest of their money.
Having a more ‘robotic’ investment style might help investors overcome loss-aversion bias. Strategies like dollar cost averaging or value averaging can help with this.
2. Regret-aversion bias
Regret aversion occurs when investors don’t take action because they fear the consequences of being wrong. Bob never bought bitcoin in early 2017 because it was safer to do nothing.
Investors like Bob fear the regret of making the wrong decisions. This can lead them to:
- Be too conservative in their investment approach by only sticking to ‘safe’ investments. This can sacrifice their long-term returns.
- Always ‘go with the herd’. This way if they are wrong it wasn’t their decision.
Diversification is the best known cure for regret-aversion bias. This reduces the risk of being wrong overall.
3. Self-control bias
Self-control is essential for success in any long-term venture. Investing is the same.
Self-control bias arises when investors don’t have a disciplined long-term wealth building plan. Jane spends most of her salary each month paying for her lavish lifestyle, instead of saving and investing for her retirement.
Investors like Jane often:
- Don’t have enough retirement savings when they get old.
- Take too much investment risk to compensate for their lack of savings. Hence they must ‘win big’ to make up for years of not investing.
The tortoise usually beats the hare in investing. And the power of compound returns shows us why long-term discipline pays off.
4. Status quo bias
Status quo bias occurs when investors stick with what is currently working for them, rather than making changes where needed. Joe bought Tesla for $30 in 2017. Since then his Tesla stock has gone up ten times. As a result, it now takes up too much of his total portfolio.
Investors like Joe might:
- Hold portfolios that are skewed too much towards a single investment. This results in high overall risk.
- Not consider alternative investment options that could have more upside.
Portfolio rebalancing can helps us overcome status quo bias.
5. Overconfidence bias
Being overconfident rarely pays off when investing or trading. Jimmy has a couple of good trades under his belt and believes he is now a true market wizard. He decides to leverage up on his next trade because he is sure he will win. He then takes a huge loss but can’t understand why.
Investors like Jimmy often:
- Take personal credit when they are right but blame ‘the market’ when they are wrong.
- Take too much risk when investing; usually with high leverage and little diversification.
- Trade too often because they think they are always right. This results in high trading costs, which eats into their returns.
Overconfidence bias leads to poor risk management. Learning how to manage risk effectively is essential here.
Investing can be highly emotional at times—this is human nature. But if we let these emotions get on top of us they can lead to poor investment choices. By setting achievable long-term investment goals while managing our short-term return expectations, we are more likely to keep our emotions in check.
Disclaimer: none of this is investment advice. These 5 biases are listed in the CFA level 3 syllabus. All names used in the examples of this post are fictional and random.