Traditional Finance tells us that investors use statistical tools and reasonable information when choosing investments like stocks, bonds, and cryptocurrencies.
Despite this informational advantage, 85% of active funds underperformed the benchmark S&P 500 index, and over a 15-year horizon, nearly 92% of active traders trail the index.
In recent years, the debate between behavioral finance vs traditional finance on why investors underperform has been a hotly contested topic between academics, practitioners, and active traders.
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Definition of Behavioral Finance
Behavioral finance studies how psychological, social, and emotional factors affect the financial decision-making process of individuals and institutions. It examines how cognitive biases, heuristics, and emotions can lead to irrational financial decisions and how these biases can be overcome or minimized to improve decision-making.
In essence, behavioral finance is the intersection of psychology and finance and seeks to understand and explain the human behavior behind financial decisions.
Concepts of behavioral finance show that cognitive biases are the primary reason for most investors underperforming in the market.
So what is an investing bias, and how can you overcome it to be a better investor?
Let's take a look at some behavioral finance examples.
What is an Investing Bias?
An investing bias is an irrational preference held by individuals that cloud their judgment and result in mistakes that can cost long-term returns. Biases can be conscious and unconscious but tend to lead to poor investment decisions.
Cognitive Biases are hard-wired into most investors, and everyone is liable to take shortcuts, oversimplify complex investment decisions, and become overconfident in the decision-making process.
Investors can make better investment decisions when they understand their investing bias, leading to lower risk and improving returns over time.
Types of Behavioural Finance Bias and How to Beat It
A few common behavioral finance biases impact even the most seasoned investor. Here's a list of investors' most common biases and how you can prevail against them.
1. Overconfidence in Behavioral Finance
The Most cited and well-known investment bias has an outsized effect on trading returns but is often misunderstood by traders.
James Montier surveyed 300 fund managers, asking how many believed they produced above-average trading returns. The results were not surprising since 74% of the participants thought they produced above-average returns, while the other 26% said they had average returns.
In short, no one thought they underperformed the benchmark, which is statistically impossible. This overconfidence then plays a role in the returns generated over the long run.
Since a large part of investing involves making financial projections for the future, overconfident investors may overestimate their ability to identify successful investments, resulting in underperforming the market.
Beating the Overconfidence Bias
Being overconfident makes even the most seasoned investor make one move too many in a bid to chase returns and beat the market, ultimately resulting in underperformance.
Behavioural Finance suggests making fewer trades, focusing on fundamental value creation, and beating out markets over the long term (in other words: being patient and investing in high-quality businesses).
2. Snake Bite Effect Behavioral Finance
The Snake Bite Effect in Behavioural Finance refers to investors becoming risk averse after losing money on an investment. This is because investors weigh losses twice as heavily as potential gains.
Beating the Snake Bite Effect
The Snake Bite Effect is based on the premise that investors are likely to be conservative after making a bad investment. To beat the bias, investors need to consider each investment independent of the other.
For instance, if a coin is tossed thrice, it turns out that the outcome is headed all three times; the probability that the next coin toss would be heads is still 50%.
Investors need to similarly analyze every subsequent investment (even after a loss in their previous investment) and make a logical decision independent of the previous investment.
3. Disposition Effect
The disposition effect was coined by economists Hersh Shefrin and Meir Statman in a study in 1985, which suggests that stock pickers sell winners early and hold onto losers for too long.
The disposition effect is an applied behavioral finance concept that essentially leads to the largest segment of the market underperforming the market. Investors likely sell their winners in 76% of the outcomes instead of holding on to them until it maximizes their return.
On the other hand, investors also fail to cut their losses early, hoping for a rebound in the stock, only to lose more money.
This was witnessed during the GameStop, AMC, and Bitcoin trading frenzy, when investors continued to hold assets despite a 50%, 60%, and even 70% decline over the Fear Of Missing Out (FOMO) of another such rally.
Beating the Disposition Effect
Investors can beat the disposition effect by looking at the fundamental underlying value rather than being emotionally attached to the purchase. This will allow them to continue doubling down on the winners while facing the hard truth about the losers and cutting their losses when there's any material change in the underlying fundamentals.
4. Anchoring Bias
The anchoring bias in behavioral Finance is a simple premise that involves investors being fixated on the purchase price or a mental price in their head rather than objectively valuing the business.
For instance, if an investor bought Apple stock at $150 a year ago, hoping to sell it at a 20% return at some point in the future, they would have made a significant error.
Apple stock, on 20 separate occasions, traded between $175 and $179.60 but never crossed the psychological price barrier of $180 (which is the threshold for the 20% return), so an investor who would have bought in then would now be holding shares valued at $153, instead of selling it for a hefty profit of close to 19.5%.
Overcoming the Anchoring Bias
With Anchoring, investors need to ensure a margin of safety in and around their buying and selling prices. So, rather than being fixed to an arbitrary number, it's essential to make an entry into the investment.
5. Representative Bias
When investors exhibit this bias in investing, they label an investment as good or bad based on its recent performance.
There were many reports of Netflix losing its competitive edge and Meta Platforms' sinking profitability, with both stocks declining to multi-year lows. However, since then, both stocks have rebounded, posting gains of 100%, with the narrative changing that Netflix would unlock value from its existing subscriber base and Meta would focus on its core business to drive profitability.
This suggests that price drives the narrative rather than the underlying value.
Overcoming the Representative Bias
Investors need to focus on the underlying value that drives the stock rather than the price itself. While the market drives the price, the underlying value represents the long-term picture of the organization.
Behavioral Finance - Conclusion
Investing biases can significantly impact an investor's portfolio performance, leading to underperformance compared to the market. Therefore, overcoming these biases is crucial to becoming a successful investor.
Investors can make better decisions based on objective and rational information by understanding and identifying cognitive biases.
Integrating behavioral Finance and traditional Finance can help investors overcome their investing biases and achieve long-term financial success. Ultimately, overcoming investing biases requires discipline, self-awareness, and a commitment to learn and improve one's investment approach continuously.
