How do behavioral biases affect investment decisions? #3

This is part three in my series on biases, or unconscious prejudices, which commonly have a negative impact on investors. 

It may look like a numbers game, but investing is really all about people. It is crucial to identify your unique traits and desires, and tailor your financial goals accordingly. It is also crucial to understand how you will reach those goals, and how you might get in the way of achieving them. In my 8 article series, I will walk you through eight biases that often interfere with a sound investment strategy. Certain psychological tendencies can sabotage our best efforts to grow wealth, so acknowledging and taking steps to mitigate them is key to long-term success. We help all our clients develop financial goals and remove the obstacles to those goals.

Disposition Effect Bias – Article #3

Remember that friend in college who wouldn’t break up with her boyfriend even though he ignored her, criticized her and never took her on dates? If that friend’s boyfriend was an investment, experts would say she was probably exhibiting Disposition Effect Bias, or our tendency to hang on to losing investments because we have labeled them as “winners,” and don’t want to be wrong. Disposition Effect Bias explains why people hold on to securities even when those securities no longer have any upside.

In the short-term, stocks that have performed well for the prior six months are likely to continue doing well, and those that have lost value are likely to continue to do so. But studies show that investors tend to sell when a stock’s value increases and hold on to a stock that is decreasing in value. The Disposition Effect Bias is behind this contrarian behavior: People hold on to a losing stock because they don’t want suffer through the negative emotions associated with loss and sell winning stocks quickly to make themselves feel better for previous losses.

Researchers have shown that, the more sophisticated an investor is, the less likely he or she is to exhibit behavior associated with Disposition Effect Bias. Put another way, the less an investor knows about investing, the more he or she will tend to hang on too long or sell too early. One way to mitigate this bias, aside from spending long nights reading up on the markets, is to allow trusted and credentialed experts to assist you with your financial strategy.