Here are The Most Common Behavioural Finance Biases Investors can Succumb To And How to Avoid Them

If you’ve ever looked back on an investment decision and not been able to comprehend how you could’ve made it, the answer is that you likely fell to one of the many common behavioural finance biases.

The reality is that human psychology often drives irrational investment decisions, whether good bad or indifferent, but we just think we are acting rationally. But recognising. biases helps avoid emotional mistakes.

In this article, we look at 6 of the most common biases, and outline strategies to mitigate them.

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The Most Common Behavioural Finance Biases Investors can Succumb To

Overconfidence Bias

This is overestimating your ability to pick winners or time the market. For instance, you may believe that you can beat the ASX 200 every year without solid research. It leads to excessive trading, high fees, higher risk, and possibly higher losses.

Loss Aversion

Pain from losses feels larger than pleasure from gains. Investors hold losing stocks too long or sell winners too early. So you may keep a stock that fell 30% hoping it will rebound, rather than reallocating to better opportunities. But this can lead to a much larger loss than selling out early.

Herding/Social Proof

This is probably the most common. It involves following the crowd instead of independent analysis. It leads to buying at market peaks and selling at troughs. A common example jumping on a “hot stock” everyone is talking about on social media or hyping up. We’ve seen this plenty of times – in fact, there is a very term ‘meme stock’ that alludes to this.

Anchoring Bias

This is relying too heavily on the first piece of information you get. Not just buying a stock just because you heard a ‘hot tip’ but it can also involve ignoring new data or overvaluing historical prices.

Recency Bias

This involves giving more weight to recent events than long-term trends. You may either buy a stock that’s been sold down when investors have hope things will improve, such as if the CEO is replaced. Or you may sell a stock when an incident like a cyber attack occurs and you think that should change your entire thesis.

Confirmation Bias

This bias is not unique to the stock market. It involves seeking information that confirms your existing beliefs and/or being blind to information that does not. So you may fall into the trap of overlooking warning signs or contradictory data.

So, How to Mitigate Biases? 

In our view, the best way is having a long-term investment plan and sticking to it. The plan should involve diversification (in terms of stocks and asset classes generally) to reduce emotional decision-making.

From time to time, a rebalance of the portfolio may be appropriate, but do it mechanically rather than emotionally. Seek objective data, not just opinions from social media or friends. And consider working with a financial adviser to provide a rational check.

How to structure an investment plan to avoid biases?

An investment plan needs to consider multiple asset classes, whatever time horizon suits investors (but it should be in years rather than weeks or months) and the eventual goal of an investor (i.e. for growth or income). Within stocks there should be a ‘balance’ between domestic & international equities, large & small caps and growth & income stocks.

This may seem like common sense, but you’d be surprised how often investors fail to take them into account and just buy on the hype.

Many studies suggest that asset allocation explains ~90% of a portfolio’s long-term return variability, while stock selection explains only ~10%. That shows how critical it is to get allocation right, even more than picking “hot stocks.”