How Emotions and Biases Can Influence Your Investment Decisions

As an investor, you may have heard general comments or reassurances like: “Tech stocks have been doing well all year, so they’re a sure bet!” This is an example of recency bias because you assume what has been true recently to always be true.

Recency bias could also lead you to buy when stock prices are rising (because you figure the stock price is shooting up and won’t stop) or lead you to sell when a stock price declines (because you’re worried about taking further losses). In both cases, you may be courting losses as you try to time the market.

2. Confirmation bias

Confirmation bias occurs when you tend to focus on or seek out information that confirms your existing views or conclusions, while minimizing or pushing aside contradictory evidence.

For example, let’s say you’re interested in investing in a certain AI company. But during your research, you only click on the articles or reports that cast the company (and the AI industry) in a positive light and ignore the unfavorable or critical stories because “they’re not helpful.”

If you limit yourself to information or interpret data in a way that only confirms what you already think, you could miss the warning signs that point to the potential risk of a particular investment.

3. Loss aversion bias

This is when you are more interested in avoiding losses than seeking gains.

While this may seem like a good instinct, loss aversion bias could lead you to become overly cautious and cause you to miss out on a good potential opportunity.

One classic example of loss aversion bias is when you put all your money into a savings account and avoid investing for fear of any stock market losses. While your money is relatively safe earning interest in a savings account, not investing at all could lead you to miss out on an opportunity to potentially earn a better return over time.

Loss aversion bias can also manifest itself when you choose to hold on to losing investments for too long with the hope that “things will turn around” and you can recover your losses.

For example: A particular stock in your portfolio is not doing well, and there are danger signs ahead in terms of company fundamentals (P/E ratios, drooping sales, etc.). But you don’t want to sell because you don’t want to realize the loss and you’re hoping for a turnaround. But in some circumstances, it could make sense to cut your losses early.

4. Overconfidence bias

Overconfidence is a common bias that can often lead investors astray. This is the belief that you know more about the intricacies of investing or the financial markets than you actually do. In other words, you tend to put too much faith in your own judgment or decisions.

For example, overconfident investors believe that they can consistently beat the market, pick successful stocks, or know for certain how the market will move.

Overconfident investors are known to trade too often, which could trigger high transaction costs that subtract from their returns. Overconfident investors also tend to accept excessive risk and look the other way when there’s information that contradicts their beliefs.

In short, overconfidence bias may result in flawed investment decisions, increased risk-taking, and a failure to adapt when necessary, which all could lead to potentially significant losses.

5. Herd mentality bias or the bandwagon effect

Herd mentality bias kicks in when you follow the crowd even if it goes against your best judgment. In short, you’re making a decision simply because everyone is doing it.

In one of the key early works of behavioral finance—the classic 1841 Extraordinary Delusions and the Madness of Crowds by Charles Mackay—readers learned of how “tulip mania” seized the Netherlands between 1634 and 1637, when Dutch investors paid a fortune—for a single flower. This is a classic example of herd mentality.

More modern examples may include a hot collectible (e.g., a doll, a toy, etc.) flying off the shelves, leading some collectors to sink their savings into them only to see the bubble burst shortly (leaving them with useless inventory).

The risk of “following the crowd” is that you could end up making investment choices that aren’t aligned with your goals or risk tolerance. You may be relying on the actions of other people rather than making your own informed decisions.

6. Familiarity bias

Familiarity bias comes in when you prefer to invest in things you know well or are more comfortable with.

For example, some investors may prefer to invest only in companies or industries they know, preferring the tried and true, even if there are potential diversification opportunities elsewhere. The potential risk here is that you may overlook opportunities that could offer additional diversification or potentially higher returns.

Familiarity bias can happen with savers too. If your first savings account, for example, was a traditional savings account and you’ve grown used to using that as your primary savings vehicle, you may hold yourself back from exploring other savings tools to help you earn more (e.g., high-yield savings accounts, certificates of deposit, etc.).

A few tips to help you minimize biases in your decision-making

When it comes to investing (or any financial decision), it may not always be easy to tell whether your actions are based on informed judgment or unconscious biases.

For example, overconfidence and recency bias can creep into our decision-making if we’re looking to avoid weighing the complexities of a decision. That’s when we may seek shortcuts like, “Well, this worked last time,” or “These stocks performed well recently.”

As an investor, it’s important to make sure you first understand:

• What are my investment goals?
• How long do I plan on staying invested (time horizon)?
• What is my risk tolerance?

Next, consider these tips to help you guard against the biases we went over:

• Focus on the long term. Take a step back and look at the bigger picture by considering historical data and trends.
• Ask yourself: Do I have all the information I need to make an informed decision?
• Be open to diverse perspectives and seek out different viewpoints.
• Review and challenge your own investment assumptions.
• Stay informed and avoid getting caught up in the latest market hype or social media trends.
• Make decisions based on your own goals, rather than those of others. Don’t succumb to herd mentality.
• Consider both the potential benefits and risks of your decision. Does it support your long-term financial plan?

Keep in mind that it’s not always easy to avoid biases, even when we’re conscious of them. And no matter how vigilant we are, we cannot completely eliminate their influence on our decision-making.

That’s why, whether you’re new to investing or a veteran, it’s a good idea to seek the help of a professional financial advisor if you’re facing a tough investment decision. They can provide the clarity and the objective analysis you need to help you make a decision that’s appropriate for your investment goals. They can also help you come up with a disciplined investment strategy that you can stick with during uncertain times.