The greatest obstacle to successful investing is often the investor themselves.

Human beings are hard-wired with biases that are designed to make our lives easier – everyone has them, and they’re a way for your mind to automate decision making. But they can also make us our own worst enemy when it comes to investing. These biases can cloud our judgment, impair our decision-making ability, and lead us to make costly mistakes. In this article, we will discuss some of the most common biases that affect investors and explain how they can be overcome.

Confirmation Bias

Confirmation bias refers to the tendency for individuals to seek out information or evidence that confirms their pre-existing beliefs or assumptions, while ignoring or dismissing information that contradicts those beliefs. This bias can lead to distorted thinking, flawed decision-making, and a failure to consider alternative perspectives.

A real-world example of how confirmation bias can impact investors can be seen in the case of the tech company Theranos. In the early 2000s, Theranos claimed to have developed a revolutionary blood-testing technology that could run multiple tests on a single drop of blood. Investors, including high-profile individuals such as Rupert Murdoch and Betsy DeVos, poured millions of dollars into the company based on the promises of its founder, Elizabeth Holmes.

However, despite the hype surrounding the company, there were numerous red flags and warning signs that the technology did not actually work as advertised. Nevertheless, investors who had already bought into the company's vision and potential for success continued to invest more money and ignore the mounting evidence against Theranos. This confirmation bias ultimately led to significant losses for many investors when the truth about the company's technology and practices were eventually exposed.

Hindsight Bias

Hindsight bias is our tendency to look back at an event we could not predict at the time and think the outcome was easily predictable. It is also called the ‘knew-it-all-along’ effect. This bias can be dangerous because it can lead investors to overestimate their ability to predict future events and underestimate the importance of luck in investing. To avoid hindsight bias, investors should focus on making decisions based on the information they have at the time and avoid second-guessing themselves.

After a stock market crash, investors may look back and believe that they "should have seen it coming," even though the crash was difficult to predict at the time. Similarly, after an unexpected event, people often say "I knew it all along" when, in reality, they did not.

Loss Aversion

Loss aversion is the tendency to feel the pain of losses more acutely than the pleasure of gains. Investors who are influenced by loss aversion tend to be overly cautious and may miss out on opportunities because they are afraid of losing money. To overcome loss aversion, investors can use risk management techniques such as diversification, options trading (with education & caution), and stop-loss orders to limit their exposure to losses.

An example of this might be an investor holding onto losing investments for too long or avoiding taking on risks that may be necessary for long-term portfolio growth. Investors may hold onto losing stocks longer than they should because they fear realizing a loss. An investor may hold onto a stock that has already lost 50% of its value, hoping that it will eventually recover rather than cutting their losses and moving on to a more productive strategy.

Illusion of Control

The illusion of control is the tendency to overestimate one's ability to control outcomes that are, in fact, beyond our control. Investors who are influenced by the illusion of control may become overly confident in their ability to pick winning investments and may take unnecessary risks. Individuals who are highly intelligent may have a greater capacity for complex reasoning and decision-making, but this can also lead to overconfidence in their ability to predict market movements or pick winning investments. For example, an investor may think that by watching the stock market every day and constantly making trades, they can control the performance of their portfolio.

To overcome the illusion of control, investors should focus on the factors that they can control, such as their investment strategy, risk management techniques, and portfolio diversification.

Framing Bias

Framing bias is the tendency to be influenced by the way information is presented, rather than the information itself. For example, investors may be more likely to invest in a stock that is presented as a "hot tip" than in a stock that is presented as a "good value." To avoid framing bias, investors should focus on the underlying facts of an investment and not be swayed by the way information is presented to them.

Recency Bias

Recency bias is the tendency to give more weight to recent events than to events in the past. Investors who suffer from recency bias may be more likely to make decisions based on recent market trends, rather than on long-term market fundamentals. This bias can be dangerous because it can lead investors to chase market trends, rather than investing in a well-diversified portfolio. To avoid recency bias, investors should focus on the long-term fundamentals of an investment and not be swayed by short-term market trends.

For example, if a stock has performed well over the past few months, an investor may assume that it will continue to perform well in the future, without considering broader market trends.

Anchoring Bias

Anchoring bias is the tendency to rely too heavily on the first piece of information that we receive when making decisions. Investors who suffer from anchoring bias may be more likely to make decisions based on the first price they see for an investment, rather than on the current market value. This bias can be dangerous because it can lead investors to buy stocks that are overvalued or to sell stocks that are undervalued. To avoid anchoring bias, investors should focus on the current market value of an investment and not be swayed by the first price they see.

For example, an investor may fixate on a company's initial public offering (IPO) price, even if the company's performance since going public has been lackluster. They may hold onto the stock, hoping that it will eventually reach the IPO price again.

“Yeah, but I’m smarter than the average bear…”

The biases discussed above are just a few examples of the many biases that can affect investors. While each of these biases may seem small on its own, they can have a significant impact on investment decisions and can lead to underperformance compared to the market index. In fact, studies have shown that the average investor's returns are significantly lower than the returns of the market index.

• The Dalbar, Inc Study: Found that over the 20-year period from 1998 to 2017, the average investor's return was only 5.29% per year, while the S&P 500 index returned an average of 7.2% per year. This significant underperformance can be attributed, in part, to the biases that investors bring to the table.

• The Barber and Odean Study: This study, published in 2000, analyzed the trading activity and performance of more than 66,000 households over a six-year period. The study found that the households' investment returns were significantly lower than market returns, and that this underperformance could be attributed to overtrading and poor stock selection.

• The Fidelity Study: This study, published in 2014, analyzed the performance of Fidelity customers over a five-year period. The study found that the investors who performed the best were those who had either forgotten about their accounts or had passed away, indicating that active trading and market timing were detrimental to long-term performance.

• The Vanguard Study: This study, published in 2015, analyzed the performance of Vanguard investors over a 10-year period. The study found that the average investor underperformed the market by 1.5 percentage points per year, largely due to poor timing decisions.

How do we address the problem?

Investors can overcome these biases by taking a disciplined approach to investing. This means developing a well-thought-out investment plan that takes into account their investment goals, risk tolerance, and time horizon. It also means sticking to that plan and avoiding the temptation to make impulsive decisions based on emotions or short-term market trends.

There are several techniques that investors can use to overcome cognitive biases:

• The first step is to become aware of your biases. Once you are aware of them, you can take steps to prevent them from influencing your investment decisions.

• Learn about cognitive biases and how they affect decision-making. This will help you recognize when you are being influenced by a bias.

• Diversify your portfolio to reduce the impact of any single investment decision. Investing in index funds or other passive investment vehicles that track a market index rather than trying to pick individual stocks. This will help mitigate the effects of overconfidence and confirmation bias.

• Dollar-cost averaging is the practice of investing a fixed amount of money at regular intervals, regardless of market conditions.

• Avoid impulsive decisions by taking time to consider your options. Delayed gratification can help reduce the influence of loss aversion and other biases.

• Seek out opposing viewpoints and challenge your own assumptions. This can help reduce the effects of confirmation bias.

• Develop checklists to guide your investment decision-making process. This can help prevent oversights and mistakes caused by cognitive biases.

• Find a mentor who has experience in the investment industry and can provide guidance and advice.

How does my financial advisor play a role?

Working with a financial advisor can potentially help investors overcome some of the biases that can lead to underperformance. Financial advisors can provide objective advice and help investors develop a disciplined investment plan that takes into account their goals, risk tolerance, and time horizon. This can help investors avoid impulsive decisions based on emotions or short-term market trends. Financial advisors can also help investors understand and overcome specific biases that may be impacting their decision-making.

However, it's worth noting that working with a financial advisor does not guarantee improved outcomes. Advisors can also be subject to their own biases and may not always provide optimal advice.

In conclusion, biases are an unavoidable part of being human, but they can be a significant obstacle to successful investing. By understanding the common biases that affect investors and taking a disciplined approach to investing, investors can avoid making costly mistakes and achieve better returns over the long term. Remember, sometimes the biggest challenge in investing is not the market, but rather ourselves.

 

DISCLOSURES:

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Consilio Wealth Advisors, LLC (“CWA”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.