What takes place in investors' minds when they buy assets, hold on to stocks, trim their positions and make other decisions with their capital? Knowing how investors think can lead to a better understanding of financial markets and help you make better investing decisions.
"Behavioral finance studies why investors make decisions for and against their best interests," says William F. Spencer, a certified financial planner, director and wealth planner at Crestwood Advisors. "It looks at cognitive and emotional biases that help us make sense of the world."
While it's hard to guess every thought that goes through an investor's mind, there is a branch of finance that covers this topic. Behavioral finance explores some of the common patterns and biases that shape investors' actions and, ultimately, their portfolios.
How behavioral finance affects the stock market
The stock market presents investors with many data points that can help them make well-informed, logical decisions. While we have the resources to make logical decisions, emotions drive most of our decisions. According to research from Nobel Prize-winning psychologist Daniel Kahneman, emotions are in the driver's seat for 90% of our financial decisions.
Emotional investing lets things like fear, ego, greed and sadness get in the way of sound investment decisions. Kahneman's research points to financial professionals, in particular, who may believe they are immune to financial biases due to their expertise.
Behavioral finance makes it easier for us to catch ourselves in the act of emotional investing in real time. It's a way to double-check yourself and take some time to pause before your emotions pull you away from logic. These are some of the biases that drive investor behavior:
- Anchoring bias.
- Herd mentality.
- FOMO (fear of missing out).
- Confirmation bias.
- Familiarity bias.
- Loss aversion.
Anchoring bias is the tendency for investors to rely on the first piece of information they find when making judgments. Michael Barbera, a consumer psychologist on the faculty of the University of North Carolina at Pembroke, explains how anchoring bias can affect investors: "An anchoring bias is likely to influence an investor to choose one asset over another based on the perception that a lower-valued asset appears to be a good deal or opportunity."
Investors may find a stock that looks promising and proceed to ignore similar stocks with more attractive price points. They may also hold onto a bearish narrative even as new information arrives that points to a bullish investment. Investors can also mistakenly hold onto bullish narratives for too long and become unaware of bearish developments due to anchoring bias.
Herd mentality taps into the strength of the crowds and gets investors to follow the momentum. Many investors jump into the action without considering why the momentum started and if it is sustainable. Herd mentality embraces the idea that something must be good because everyone else is saying that it is good.
Investors with this bias may jump in with the crowd and ignore dissenting opinions. Herd mentality can lead to losses as investors with this bias wait to react to other market participants instead of taking the initiative.
FOMO (Fear of Missing Out)
FOMO, otherwise known as the fear of missing out, is an investing bias that branches into other areas of our lives. It's one of the most powerful forces that can lead to substantial losses and ties in with herd mentality. While FOMO and herd mentality are similar, Barbera says scarcity is the driving force behind FOMO.
"In behavioral finance, the fear of missing out is categorized as scarcity," he says. "Scarcity refers to a cognitive bias that influences decision-making by placing an exaggerated emphasis on the limited availability of a resource rather than its actual intrinsic value. This bias can lead individuals to perceive items or opportunities as more valuable simply because they are scarce or rare, regardless of their true worth."
Confirmation bias is a tendency among investors to only look for information that validates their opinion. For instance, an investor who feels bullish about a certain stock may only read articles that express bullish sentiment. This same investor may ignore articles that point out why the stock is overvalued. Knowing both sides of an argument can help investors make better decisions, but confirmation bias makes people less likely to consider both viewpoints.
Familiarity bias reflects many investors' desires to stick with industries and assets they know well. Some investors may stick with tech companies but not bother to look at corporations in consumer staples, health care and other non-tech industries. Familiarity bias can hurt an investor's ability to create a diversified portfolio and mitigate risk. Index funds can offset familiarity bias by giving you exposure to a wider range of stocks and sectors.
For many investors, the fear of losing money is stronger than the positive feeling from making money. This phenomenon reflects loss aversion, and Spencer mentions that this investing bias is normal.
"Loss aversion is natural and affects everyone. People seek pleasure and want to avoid pain," he says. So it's common for a 2% drop in account value to make a greater impact on an investor than a 2% gain.
Loss aversion can cause investors to miss out on great opportunities, especially if they are still thinking about previous losses. The stock market can continue to soar as investors experiencing loss aversion may believe that a bear market will grip assets at any moment.
While a bear market may eventually arrive, investors can miss out on significant gains by taking an overly defensive stance. A defensive strategy can be necessary at times, but some investors ignore promising catalysts due to loss aversion.
Many factors influence asset prices. Some of these factors are as plain as day, while others are less visible. Even when catalysts suggest a bullish or bearish trend, the market can go in the opposite direction for an extended amount of time.
Despite all of the factors influencing the stock market, investors can become overconfident if they make a few good trades. Overconfidence can lead to investors believing they can predict the stock market even though it's impossible to anticipate every possible factor that can drive asset prices.
Overconfidence can result in investors making riskier investments, believing they will always generate higher returns than market indexes. This strategy works until it doesn't, but continuing to make high-risk investments can lead to an implosion when overconfidence runs into reality.
How to keep your emotions in check
Behavioral finance isn't meant to intimidate investors. However, this branch of finance can help both new and experienced investors stay humble, understand common pitfalls and adjust their portfolios accordingly.
Keeping your emotions in check is easier said than done. Barbera offers some strategies to minimize FOMO, which can apply to other investing biases: "An effective measure for resisting FOMO could be time. Large purchases, investments or significant decisions should be made with low time pressure, meaning that there is ample time to make a decision."
Barbera adds, "The person making the decision should remove themselves from the physical environment where the decision is taking place in order to reflect and place a temporal gap between themselves and the scarcity-influenced decision. This is likely to influence the decision-maker to be more objective in the decision process."
Taking a patient approach instead of rushing into time-sensitive investment opportunities can lead to better outcomes. You have more time to think, which can lead to better decisions. Taking the time to write down your thoughts on money and understanding how biases impact your decisions can also help.
"Investors can keep their emotions in check by becoming more aware of them. Money is a personal topic that reflects our values. Because of that, it can create a lot of feelings no matter what the situation is," Spencer explains. "One can pause and notice what is going on for them. Once you have learned how you feel about the money thought, you can decide not to act on unhelpful thoughts and move forward onto helpful ideas."
It's important for investors to monitor their emotions when dealing with money. Knowing the investing biases and keeping track of how you manage your money can help you become a more successful investor.