Our Biases Hurt How We Invest

Have you noticed that some investors buy stocks when the market is soaring to new heights and sell when the market falls off a cliff? Or that they insist on holding onto an underperforming investment for years? Why is that?

When I studied finance in the early 1980’s, investor behavior was based on the efficient market hypothesis which says that investors behave rationally and that markets contain all relevant existing information. That theory was challenged in the mid-80’s with the emergence of the field of behavioral finance (a sub-field of behavioral economics[1]). Behavioral finance economists argue that investors are influenced by biases which lead to bad decisions.

Here are a few examples of common investing biases.

Following the Herd

People instinctively behave the same way that a large group (e.g. the herd) does regardless of whether the herd’s behaving rationally or irrationally. We follow because society wields a lot of influence when it comes to conforming and because we assume that such a large group can’t be wrong. Do you remember the dot.com stock bubble? I was living in Silicon Valley at the time and working in tech. As part of my job I visited large infrastructure hosting sites. I saw hundreds of cages filled with IT people setting up their servers and networks. I felt like I was watching tech’s version of the 1849 Gold Rush! Everyone was talking about what stocks they were investing in. Looking back it’s clear that we were behaving irrationally. More recently there was the market collapse following the financial meltdown and housing bubble in 2008. The DOW dropped down to 6000 and people wondered whether this was the end of our economy. I remember a friend tell me that he just couldn’t take it anymore. He ended up selling all his stock near the bottom.

Confirmation Bias

This refers to our desire to obtain information that validates our beliefs and ignore information that doesn’t. Confirmation bias leads to investor overconfidence and bad decisions. Here’s an example. Many people invest heavily in the stock of the company that they work for. Management shares their plans – revenue growth, new products, and expansion – with employees. It all sounds so good! So they load up their 401K’s with company stock. Unfortunately they don’t seek out more objective information because they want to believe. But by loading up on company stock, they assume tremendous risk because their investment portfolios are not properly diversified. This can put their retirement plan in jeopardy if and when the company’s fortunes change. (Think Enron.)

Loss Aversion

Loss aversion says that people value losses and gains differently. We feel the pain of a loss more intensely than the pleasure of a gain. This leads investors to sell too soon or hold onto losing investments in the hope that they will recover enough to at least come out even. It’s difficult to watch an investment’s value decline, or decide when it is time to sell, take a loss and then reinvest that money in something that has a better chance of success.

How to Counteract Biases

Of the many ways to counteract these biases, here two tactics that I use: 1) slow things down; and 2) use a technical tool to enforce discipline.

First, I slow down my intake of financial news and how often I check my investments. Not only does this keep me from getting caught up in herd behavior but studies have shown that investors who check their investments less often have better results (possibly by avoiding overreacting to loss aversion bias).

Second, I use a simple technical tool called the Relative Strength Index (RSI). It provides clear buy and sell signals which helps take the emotion out of the decision.

Here’s an example.

Let’s say that I want to purchase Fidelity’s Floating Rate Fund (FFRHX). Before I act, I first check out Yahoo! Finance’s interactive chart including the RSI indicator.

The area to key on is in the lower right corner. The RSI indicator is at 82.76. Note that an RSI reading of 80 or more is a “sell” signal while a reading of 20 or less is a “buy” signal. If I bought today, it’s more likely that I’m buying at the high end of the price range. By waiting for the indicator to drop, I’ll increase my chances of buying at a lower entry point. Using the RSI  helps slow things down and avoid confirmation bias.

How do you deal with investment biases? Please feel free to share your experience either in the “Leave a Reply” field below or by using the Contact Us form.

[1] Check out Freakenomics’ podcast with author Michael Lewis about his book The Undoing Project which features the birth of behavioral economics.

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