Behavioural Finance: How Your Biases Can Harm Your Investment Success
In theory, investing in publicly listed companies is easy. The longer you stay in the market, the greater your returns will be. In practice, however, our investment success may be hindered by certain natural biases that cause us to make irrational investment decisions. Behavioural finance teaches us how to recognise these behavioural flaws and how to avoid pitfalls.
With twenty years of experience in private equity, venture capital and the stock market, I have learned the hard way thatpersonal biases can curb one’s chances of having real life-changing returns. In this article, I will describe six common biases that emerge when we are investing and give you recommendations for successful investment decision-making.
What is Behavioural Finance?
Behavioural finance studies the psychology behind financial decision-making. It argues that people base their investment decisions on emotions and biases, such as fear, greed and herd mentality. This goes against traditional finance theory, which assumes that investors are efficient and rational decision-makers, who don’t get distracted by emotions, personal biases, or internet bubbles… You get my point. People are only human, and so is their financial decision-making.Behavioural finance explains how the stock market can be driven by (irrational) biases and emotions. This helps us analyse our financial decision-making and boost our future returns.
Let’s illustrate this with a look at the current stock market. After the global stock market crash from late February of this year, when the world was shaken by the news of the Covid-19 pandemic, the stock markets quickly recovered to re-enter a bull market. Since then, the markets have seen an influx of so-called “Robin Hood Investors,” a new generation of investors who saw stock trading as a fun and profitable alternative to gaming and watching sports during the global lockdowns. These new investors have never experienced a serious downturn and seem to think that “the only way is up.”
This kind of exuberance is usually a warning sign that the markets may be near their top and are due for a correction. For this new generation of investors, this means that they will have to deal with a downturn for the first time. To ensure their future returns, they should be aware of how the investment decisions they make to manage the downturn may harm their future returns.
Why? This is where the psychology of financial decision-making comes into play. In the following, I will explain the role of emotions in stock trading and describe six of these potentially harmful biases that affect our decisions.
How our Emotions Impact our Investment Decisions
As I said at the beginning of this article, investing in stocks is easy. Well, in theory. The stock market is like a casino, but with the investor being the house. The longer you stay in the market, the higher the probability that you will make a good return. This can be illustrated with a look at the S&P 500 Index. Since 1942, the S&P went up for 62 years and down for only 16 years. Also, the upwards years were good for an average of 19%, while the downwards years were just a little over -12% on average.
So, for the long-term investor, making a good return is actually quite easy. The difficult part, however, and the one most affected by our emotions and biases, is going through the (inevitable) downturns. Being patient and waiting until your stocks recover and go up again is one of the most difficult parts of investing, and it is the part where many will fail. As a result, most individual investors — and even professional ones — will eventually underperform the S&P, studies have shown.
Why is that? This is where decision-making psychology comes into play. Let’s have a look at the chart below, which is an excellent example of the emotional rollercoaster that most of us are probably on when investing in the stock market, and how these emotions may impact our investment decisions:
Having an understanding of human instincts and the emotions and psychological biases that may influence your investing behaviour will help you a great deal in avoiding them. Though it may be impossible to ignore your biases completely, being aware of them is the first step to becoming a successful investor.
Behavioural Finance Biases: Six Examples of Behavioural Pitfalls
Now, let’s have a look at some examples of the behavioural biases likely to affect your stock trading behaviour. Also, I will give you recommendations on how to avoid these pitfalls.
1. Action Bias
Imagine a goalkeeper getting ready for a penalty kick. Though statistics have shown that by staying in the centre of the goal — that is, by doing nothing — they have the greatest chance of stopping the penalty, they usually choose to jump left or right. In psychology, this unfortunate decision-making is called the action bias: The goalkeeper, confronted with the possibility of a goal, decides to take action, driven by this human instinct that he or she has to do something to control the situation. Even when it doesn’t work.
This impulse to act is also common among individual investors, especially the ones who also suffer from overconfidence, which is the bias that I will discuss next in this article. Active trading comes at a price. Research has shown that individual investors who attempt to beat the market usually end up losing by wide margins from the index funds. Or, as researchers say: Trading is hazardous for your wealth.
The remedy? Trade less and be patient. Accept that you probably won’t be able to beat computers, professional investors and anyone else who is better informed than you. My advice? Pick a good company to invest in and sit on your hands. It may be harder than you think.
2. Overconfidence Bias
Think of a talent show. A candidate who believes themselves to have a great voice gives a horrible performance and ends up being laughed at by the jury. This is a good example of overconfidence, another behavioural bias that may harm your investment success. This bias can go two ways. You may be too confident in the quality of your information or you may be too self-asserted about your ability to make the right decisions at the right time.
The consequence? Studies show that overconfident traders tend to be frequent traders and they lack an adequately diversified investment portfolio. And well, active traders are losing traders, as we asserted in the last paragraph.
Unfortunately, overconfidence is also very common among investors. James Montier, author of several books on behavioural financing, found that in a survey of 300 professional fund managers, 74% of them believed that they performed above average in investing. An extreme example is Dave Portnoy, founder of internet company Barstool Sports, who on June 9th tweeted:
“I’m sure Warren Buffet [arguably the best investor of all time] is a great guy but when it comes to stocks he’s washed up. I’m the captain now.”
In contrast, Ray Dalio, founder of the world’s largest hedge fund Bridgewater & Associates, is a great example of an investor who does manage to keep his confidence in check. Though, in his case, it would be justified to think he performs above average in investing. Dalio told Forbes that he attributed a significant amount of his success to avoiding overconfidence bias. “I knew that no matter how confident I was in making a single bet, that I could still be wrong,” he says.
With this in mind, Dalio plans for worst-case scenarios and takes appropriate steps to minimise his risk of loss. What can we learn from his example? Before buying a stock, always be prepared to acknowledge if you were wrong and anticipate what your plan will be in that case.
3. Confirmation Bias
Confirmation bias is the human tendency to look for information that confirms our beliefs and ignore information that contradicts our way of thinking. This may be one of the biases most difficult to avoid, as practically any human being is likely to fall prey to this tendency. Just think of the news outlets that you follow. You may read the New York Times and The Guardian. Or maybe you distrust all mainstream media. Either way, you are probably choosing your sources based on what you already believe in, and you may look at other media with distrust. Or, think of the conspiracy theories that masses of people firmly believe in.
This bias also affects our investment decision-making — and in a quite disastrous way. Imagine an investor who hears that one of his portfolio companies may go bankrupt. He or she will be worried and will think about selling their stock. But instead of having a rational look at the available information, the investor will only notice the news that confirms his/her suspicions and will finally sell the stock at a loss. Then, the company recovers and its stock goes sky-high.
So, what to do? It’s quite simple. Instead of searching for information that confirms your beliefs, try to find information that challenges your ideas and look for all the information you can get on a stock to reach an unbiased conclusion.
4. Loss Aversion
Another very human bias affecting our investment decisions is the fear of loss. Behavioural finance theorists have found that investors weigh losses up to three times more than potential profits. Think of the shareholders of any falling stock. Many will prefer to cling to these stocks because as long as they don’t sell them, it’s not a loss. They might hold on for anirrationally long period, until it’s too late and the stock has lost all of its value.
So, how can you avoid this bias? Set your own trading rules and follow them. This will prevent you from trading based on emotions.
5. Disposition Effect Bias
The disposition effect bias may be considered a side effect of loss aversion. It finds that investors tend to sell winning investments while they hold on to losing investments. This way, they avoid having to incur a loss on a trade, as well as the pain of having to admit they were wrong. Yet, it won’t come as a surprise that this is also a losing strategy.
Selling your winners too fast will stop you from riding all the way up and will leave you with less than optimal investments. This is a bias that I have been prone to myself. Too often, I sold my stocks for a nice, quick profit of around 30–40%, only to realise afterwards that they continued going up in the years after I sold them. Yet, mentally, I felt unable to buy them back at a higher price than I had previously sold them for. Luckily, by investing mostly in venture capital at Ramphastos Investments, I have been forced to have a time horizon of at least five years, usually longer.
Because of my disposition effect bias, I missed out on huge life-changing returns in Apple, Amazon, Salesforce and Netflix — the so-called tenbaggers of the past century. Fortunately, by becoming aware of this bias, I am glad to see that I have improved on this score. Today, I have several stocks that have already gone up 1000% or more — and I have no intention to sell them anytime soon.
My advice? Hold on to your winners and get rid of your losers. Yes, it is that simple.
6. FOMO or Herd Mentality Bias
Herd behaviour is one of the biases most easy to understand and relates closely to the notion of FOMO — Fear of Missing Out. The human being has a natural tendency to imitate the other. In other words, to follow the herd out of fear ofbeing left behind. When it comes to investing, this bias results in investors buying when a stock is moving up and selling when the stock is falling, irrespective of other information that the investor may have on the company. This is caused by a fear that others may have better information. Thus, they decide to do what everybody else is doing.
Examples of this herd mentality are the Bitcoin frenzy in 2017 and 2020 or the current tendency of investors to buy every new EV (electric vehicle) stock they hear about in the hope of finding the new Tesla.
This behavioural finance bias is very prevalent in the current stock market environment. The combination of ultra-low interest rates, the announcement of vaccines against Covid-19, government stimulus packages, and high valuation multiples (an analysis method to value similar companies) explained by new paradigms causes investors to buy into these stories about the future, instead of basing their decision on a solid investment thesis.
Yet, following the herd is seldom a winning strategy. When you follow a trend, you may be buying a stock that is nearing its top, after which it could lose value.So, what can you do? Take the contrary approach: Buy when the crowd lies low and sell when they (all) buy. Be the lone herder.
In Conclusion
My last piece of advice: If you want to learn how to make money with stocks, just go out there and start trading. Though you should read as much as you can on investment theory, in the end, it is the experience that makes you a better investor. Do your research, find good stocks and be willing to recognise your behavioural flaws and biases. Regularly check thatyour investment thesis still stands. If it does, hold on to your stocks, even during corrections and bear markets.
And remember: Practice makes perfect.
About the Author
Philip van Wijngaarden (50) is a partner at private equity and venture capital firm Ramphastos Investments, founded by Dutch billionaire Marcel Boekhoorn. Philip loves working with highly motivated entrepreneurs who are determined to dominate upcoming and innovative industries. He has been involved in many start-ups and scale-ups in a multitude of industries, like aviation, telecom, fintech and gaming.
