Behavioral Finance: Understanding Its Impact on You 7 Common Investor Biases

Sachin Pratap Singh The Daily Update TDU

Discover How Psychological Influences and Biases May Affect Your Financial Behavior Even when humans have all the facts, we can make mistakes. That’s because it is difficult to remove emotions, assumptions and personal perspectives when making decisions. Morgan Stanley Virtual Advisor is here to help you overcome any potential challenges you may face while investing or financial planning

1 Behavioral finance is the field of psychology that studies how and why human biases influence financial markets.

2 These biases can impact our judgment about how we spend our money and decide to invest it.

3 Some common pitfalls include overconfidence bias,1 loss aversion2 and herd behavior.

4 Understanding biases can help you overcome them and make better financial decisions.

Understanding Behavioral Finance

While we like to believe the stock market is efficient—meaning everything is fairly and accurately priced at all times—the reality is that the market is shaped by the human behaviors of buying and selling, which can be impacted by global events, headline news and personal preferences. And, if human behavior is inherently unpredictable, market inefficiencies are inevitable. This is the foundation of behavioral finance, the field of psychology that studies how and why human biases influence financial markets.

There are countless well documented examples of behavioral finance in motion. When markets are rising, human greed can lead us to keep buying stock, even when analysts suggest otherwise.

When markets are falling, fear can lead us to sell, even when history has shown, time and time again, that the best thing to do in these situations is to stay invested.

Humans are naturally inclined to act, especially in stressful situations—and studies suggest that the bigger the decision, the greater the tendency to ignore rational factors.

7 Common Investor Biases Humans have innate biases that influence the way we view the world and make decisions, including decisions about money.

Here are some common cognitive and emotional blind spots that may affect your financial behavior:

1. Confirmation Bias
2. Loss Aversion
3. Overconfidence Bias
4. Recency Bias
5. Anchoring Bias
6. Herd Mentality

BIAS NO. 1: Confirmation Bias WHAT IT IS? A tendency to seek out information that confirms or supports what we already think and reject information that doesn't.

• WHAT IT CAN LOOK LIKE While researching a particular company's stock you think you’d like to buy, you come across positive headlines and negative ones—and click only on the ones that support your decision.
• WHY IT COULD BE A PROBLEM Limiting yourself to information that confirms what you already think may cause you to miss important warning signs.
• HOW YOU CAN HELP PREVENT IT It’s not always easy to read or hear things that disagree with your views; but challenge yourself to include those differing perspectives in your research. You may still make the same decision; however, you’ll be more informed and aware of potential issues.

BIAS NO. 2: Loss Aversion

WHAT IT IS ?

• people don’t like to lose, and loss aversion is the tendency of people to prefer avoiding losses, as opposed to acquiring equivalent gains.
• WHAT IT CAN LOOK LIKE Research suggests that someone who loses $100 will feel twice the pain versus the satisfaction of gaining $100. In other words, a person would have to gain $200 for their feelings to equalize.
• WHY IT COULD BE A PROBLEM ? If you only invest in low-risk, low-return investments, your money may not grow enough to reach long-term goals like retirement. Selling out of fear during market downturns locks in losses and may make it harder to catch up.
• HOW YOU CAN HELP PREVENT IT? Remember that when the market is down, you’ve only “lost” if you sell in that moment. Speak to a professional to become more informed and potentially hold on to your portfolio to ride out the volatility or discuss additional options before making a decision— there may be other options that could potentially lead to higher gains.

BIAS NO. 3: Overconfidence Bias

WHAT IT IS Overconfidence bias?

• It is defined as a tendency to have a misleading assessment of ourselves, a belief wrapped in ego that we’re better than we actually are.

WHAT CAN IT LOOK LIKE?

• People are overconfident about many things: their ability to drive well, their sense of humor, and their certainty that “they are absolutely right” about specific things.

WHY IT COULD BE A PROBLEM?

• This bias can lead us to believe we can accurately time the market (even though markets are unpredictable).

HOW CAN YOU HELP PREVENT IT?

• Before making investing decisions or strategy changes, especially impulsive ones, consider doing some additional research or talk your ideas through with family, friends or a professional.

BIAS NO. 4: Recency Bias:

WHAT IT IS?

• A tendency to place too much emphasis on experiences that are freshest in your memory—even if they are not the most relevant or reliable.

WHAT CAN IT LOOK LIKE?

• The financial crisis in 2008 and 2009 led investors to exit the stock market. Many had a dismal view of the markets and likely expected more economic hardship in the coming years. The experience of having gone through such a negative event increased their bias toward the belief that the event could recur. In reality, the economy recovered, and the market bounced back in the following years.
• WHY IT COULD BE A PROBLEM?
• Recency bias can lead you to buy near the top during market runups and sell at the bottom during downturns.
• HOW CAN YOU HELP PREVENT IT?
• Take some simple measures, such as looking at historical events to understand the financial market, have a clear goal in mind, and work with knowledgeable professionals to help bypass recency bias to some extent and build a strong portfolio.

BIAS NO. 5: Anchoring Bias

WHAT IT IS?

Slow reaction to economic, corporate or market developments because of an illogical or emotional attachment to a perceived value, even in the face of changing information.

WHAT IT CAN LOOK LIKE?

There are many real-life anchors in the world of investing. Individual investors create anchors about their investment expectations based on news (“Gold nearing its year-to-date high”) or talking to colleagues (“I have doubled my money on cryptocurrency”).

WHY IT COULD BE A PROBLEM

The anchors our brains choose often to have no bearing on the decision to be made. For example, whether it makes sense to buy a fund at a given price depends on factors such as your financial situation, the fund's strategy, and future prospects. The price your friend bought at is completely irrelevant.

HOW CAN YOU HELP PREVENT IT?

When making an investment decision, consider the source of the recommendation. Are your circumstances similar?

Is the timing and valuation still the same? Most importantly, would this choice support your personal goals? Thinking through these questions could help you decide whether it’s really an appropriate investment for you.

BIAS NO. 6: Herd Mentality Bias

WHAT IS IT Herding?

• is when people follow the crowd instead of their own instincts and/or analysis.
• WHAT CAN IT LOOK LIKE?
• In a well-known study, participants were asked to answer a question by a show of hands (so that everyone in the group could see how everyone else was answering). In the first part of the test, the answer was obvious, and everyone got it right. But in the second part, there were “plants” in the group who intentionally answered incorrectly—and guess what? More participants got the answer wrong, a classic example of herding, where people might be lazy, indifferent or question their own judgment.
• WHY IT COULD BE A PROBLEM?
• The crowd is often wrong, and trends can be shortlived.
• When it is, the repercussions can be costly: Think internet stocks in 2001 or meme stocks in 2021.
• HOW CAN YOU HELP PREVENT IT?
• There is something to be said about the belief that there is safety in numbers but when it comes to investing decisions, everyone’s situation is unique and personal. While it can be tempting to jump on a bandwagon, review your existing strategy and remind yourself you have a plan to reach your goals an impulsive change may end up hindering you in the long run.

BIAS NO. 7: Ambiguity Aversion

• WHAT IT IS?

People tend to be more comfortable with things that are predictable and shy away from uncertainty.

WHAT IT CAN LOOK LIKE

You might be tempted to load up on investments that offer predictable returns—like money market funds or bonds with a fixed rate of return—versus a growth stock with no dividend and uncertain returns. Alternatively, the fear of unknown outcomes could prevent you from making any decision at all, keeping you entirely out of the markets and missing out on potential opportunities.

WHY IT COULD BE A PROBLEM?

Sometimes sticking to your comfort zone is risky. For example, if your goal is to grow your money over a long time period, investments with predictable returns might not give you the best chance to achieve your goals.

HOW CAN YOU HELP PREVENT IT?

Start with defining your short- and long-term goals, and then laying out multiple choices for how you could work to achieve them in a methodical, organized way. This approach can help you get a better sense of your options. Plus, speaking with a professional about these ideas can also help you develop a holistic plan you will feel comfortable with.

“People tend to be more comfortable with things that are predictable and shy away from uncertainty.”