Behavioral Finance: Strengthen Your Portfolio Using Investor Psychology

Understanding investor psychology can help you find greater success with your investment portfolio.

Often lurking behind our financial decisions is something called investor psychology. We humans are typically emotional by nature, and by that nature, we have innate biases that can lead to poor decisions. We seek security in most aspects of our lives, and financial security is among the top concerns for most of us. However, there are times when we can be our own worst enemies, acting on instinctive behavioral biases that impact our decision-making. When it comes to our financial security and investing, the natural volatility of the stock market can easily lead us to be susceptible to making decisions based on emotion – and these decisions can often be illogical or irrational. By better understanding our own investor psychology, we can learn to make better, more informed investment decisions.

The Science of Investor Psychology

The field of study that digs into investor psychology is called behavioral finance. It examines our predisposition to think or act in a way that we are used to, or to follow a method of operation we’ve adopted over the years – this is called cognitive bias. Acting on gut feelings, which many investors also fall prey to, is referred to as emotional bias.

While you may consider yourself logical and unemotional when it comes to your finances, there is no doubt that you are also human. Since human nature alone can lead us to make mistakes, you may benefit from learning about the eight types of biases below in order to better understand your own investor psychology and identify and overcome biases in your own financial decision-making.

Confirmation Bias

Our existing beliefs, preconceived notions, and opinions tend to guide most of us in our decisions. This is called confirmation bias, also known as anchoring, and it is the bias most frequently considered in discussions around investor psychology. As humans, our brains tend to naturally pay more attention to things that support what we already believe to be true – say, that a certain stock price is going to rise. When it comes to investing, those with strong confirmation bias tendencies will more likely fixate on investment information that aligns with their existing beliefs. You can work to overcome confirmation bias by actively looking into information that contradicts your current thought process.

Regret Aversion Bias

It is a natural inclination to seek to avoid feelings of regret. When we fear that our decision will turn out to be wrong in hindsight, we exhibit what is called regret aversion bias. When investors are influenced by anticipated regret, they may fear the consequences of both errors of omission (such as not buying the right investment) and commission (such as buying the wrong investment). You may need to question yourself if you are reluctant to sell off a losing investment – are you practicing regret aversion bias? Acknowledging the investor psychology behind your actions – or inactions – may help you to move forward.

Disposition Effect Bias

There are those investors who tend to label an investment as either good or bad. This behavior often has the effect of a reluctance to sell assets that have lost value and a greater likelihood of selling assets that have made gains too soon in an effort to make up for past losses. This is called the disposition effect and is often linked to regret aversion.

Hindsight Bias

Hindsight bias is when a person looks back at an event and believes they predicted the outcome. It is a dangerous bias and can lead you to believe that your judgment is better than it is. The idea is that once we know the outcome, it’s much easier to construct a plausible explanation, when in fact you could never have reasonably predicted it. A lack of thoughtful critique of your decision can lead to poor decision-making in the future.

Familiarity Bias

Familiarity bias can be very strong among investor psychology biases, and it occurs when investors tend to invest in what they know and are comfortable with, such as domestic companies or locally owned investments. As a result, you may avoid diversifying your portfolio across multiple sectors and types of investments, which may lead to you suffering a suboptimal portfolio with a greater level of risk.

Self-Attribution Bias

Being an overconfident investor can be difficult to admit, especially if you study investing and personal finance and feel you have a great deal of knowledge. Referred to as self-attribution bias,  it is actually a concept in investor psychology research that recognizes a tendency to attribute success to personal skills and to attribute failures to those factors beyond your control. If you find yourself never taking responsibility for your own poor investment decisions, then you may suffer from this bias.

Trend-Chasing Bias

If you find yourself chasing past performance in investments, believing that historical returns can predict future performance, then you are likely experiencing trend-chasing bias. To help you overcome this investor psychology challenge, resist the urge to follow the herd. While it may cause you to feel more comfortable investing with the crowd, such a strategy is unlikely to result in strong performance for your portfolio.

Worry

Our decisions are influenced by a number of factors, including our emotions. When it comes to financial decisions, worry is a deep bias that can lead to financial errors and negatively impact your portfolio. Worry can lower your tolerance for risk and cause you to adopt an asset allocation strategy that may not align with your goals and needs.

Overcome Biases with a Professional Who Understands Investor Psychology

We all have our shortcomings, and as humans, it is inevitable that you will be impacted by a behavioral finance mistake from time to time. Investor psychology biases, such as those discussed above, stem from various sources, including the environment where we grow up and how we see people around us managing their investments. However, it’s essential to understand that human nature can work against you and deprive you of wealth-creation opportunities.

Professional help can be beneficial in every sphere of life, and investing is no exception. If you’d like to understand more about overcoming your own investor psychology challenges and building a strong financial plan for the future, we can help. At Principal Preservation Services, our experienced team of financial planners can help you make smarter decisions and build a path to greater financial security. Contact us today to learn more about our services.

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