Celestin Pepin is an experienced financial analyst who helped plan and set up a military hospital during the COVID-19 pandemic. This article will look at behavioral finance, demonstrating how psychological biases can influence financial choices and outcomes.
Even when armed with all the facts, humans can still make mistakes. This often stems from an inability to separate emotions, personal perspectives, and assumptions when making decisions. Common pitfalls include loss aversion, overconfidence bias, and herd behavior. Understanding biases helps people to overcome them, positioning them to make better financial decisions.
Biases affect people’s judgment, impacting the way they spend money and decide to invest. It may appear from the outside that the stock market is an efficient machine where everything is priced fairly and accurately. In reality, however, human behavior has a significant influence on financial markets. Buying and selling frenzies are often incited by headline news or global events. Since human behavior is inherently unpredictable, it naturally follows that market inefficiencies are inevitable. This concept is the foundation of behavioral science, a field of psychology that centers around the study of human biases and their impact on financial markets.
There are countless examples of behavioral finance in motion. As markets rise, human greed takes over, leading investors to keep buying a stock even where market analysis shows it to be overpriced. When markets falter, fear kicks in, leading traders to sell, even in situations where history has shown that the best thing to do is to stay invested. Humans are naturally inclined to take action when faced with stressful situations. Studies show that the bigger the decision, the greater the inclination to ignore rational factors.
Emotional investing behavior can lead to insufficient diversification across asset classes, moving in and out of the markets at the wrong time, and chasing market performance. Unsurprisingly, the typical result of such behaviors is poor performance in the long term, inhibiting the investor’s ability to achieve their financial goals.
The consequences of human bias are even more dramatic than people tend to assume. For example, over the past 30 years the average annual return for a balanced $100,000 portfolio comprising 65% equity and 35% fixed income assets was 8.8% according to Morgan Stanley. However, the average U.S. investor received a more meagre 4.8% return over that same period. Financial analysts attribute this to poor investment habits such as trying to time the market, chasing performance, focusing on the short term, or holding too much cash.
Furthermore, due to the effects of compounding, that difference equated to much more than just a 4% annual loss, potentially culminating in an eye-watering $840,000 deficit over that 30-year timeframe.
Common investment biases include cognitive bias resulting from the brain’s attempt to simplify information to speed up decision-making. Emotional bias is another human shortcoming investors need to be mindful of, leaving them vulnerable to making decisions based on feelings rather than logic and facts. Confirmation bias occurs where investors place greater emphasis on information that supports their existing beliefs, rejecting that which fails to align with their preconceptions. This potentially leaves investors at risk of overlooking important warning signs and making choices that lead to poor financial outcomes.
Nobody likes to lose. Loss aversion is another common investment bias that manifests itself in traders focusing on low-risk, low-return investments or selling out of fear during market downturns. Such tactics impede their ability to reach their long-term goals by returning only minimal yields and locking in losses that make it harder to catch up. When a market is down, it is important to remember that the investor only “loses” money at the point where they sell their shares. Where stocks are held in companies with excellent fundamentals, the ability to ride out volatile periods of market activity can help investors to protect their wealth.
