Biases of Behavioral Finance

by Peter Samuelson 

What is more difficult to experience - making an investment and watching it decrease in value, or selling an investment and watching it increase in value? It is a tough question and there are feelings hardwired into our brains that make you react the way you do when these situations happen. There is a term called the Prospect Theory which describes how individuals make decisions involving risk. People tend to react to a loss more than a gain because no one wants to lose money, so the potential gain must be more than the potential loss for it to be a worthy investment. Below is an explanation of a few different biases in behavioral finance to be aware of when making decisions involving risk. Understanding these may help protect you from some of the mental traps your brain can put you in. 

The first bias is the Disposition Bias. This is when investors sell their winners and hang on to their losers. Investors tend to admit they are correct about an investment quickly when they have a gain. However, they are not as reluctant to admit when they are wrong so they will hold on to their losses with hopes of it going up. Maybe it will go back up, but you should not get trapped into believing that. Think about both sides and the fact that it might be better to cut your losses and try something else.

The Second Bias is Confirmation Bias. This is when investors are more accepting of information that confirms what they already believe. In the age of the internet and social media, you can always find something that confirms what you believe. You wouldn’t be doing your due diligence when making investments if you only looked at the opinions of analysts you agree with, without looking at all sides. The COVID-19 pandemic and 2020 Presidential election are two recent examples of how Confirmation Bias plays with our thought processes.   

The third and final bias is the Familiarity Bias. This occurs when investors only purchase what they know and as a result, their portfolios are not diverse across sectors creating the possibility of much more risk of losses. An example of this is someone who works for an oil company that only invests in oil and energy companies because that is what they know. What happens if the industry crashes? They would lose a lot of money. It is important to have diversification between asset classes and sectors when building an investment portfolio. 

It can be very easy to get on a train of thought and not consider that there are other options out there, but it is critical to do so when building a portfolio, picking investments, and deciding when to buy or sell those investments. At Sawston Wealth Management, we have a disciplined investment process which is key for removing biases that may impact our behavior.