Behavioral biases that can negatively affect your investment portfolio

Whether to our detriment or to our advantage, we are human. Our impulsive and emotional nature governs how we make decisions. Rational choices are often clouded by irrational emotions. It really comes down to our DNA – our tendency to follow certain behavioral patterns is part of our psychology as human beings. However, when financial choices are influenced by the survival mechanisms in our DNA, our returns can suffer. Conversely, understanding psychological patterns can also work to our advantage. Essentially, what if it was possible to predict unpredictable humans?

Enter the study of behavioral finance, or how psychology impacts the behavior of investors and financial analysts.

“Behavioral finance includes psychology, finance, economics and sociology to understand how investors behave and how the market as a whole behaves,” says expert Razan Salem, lecturer in behavioral finance at the Northeastern University and investment and financial consultant. .

Salem’s research in behavioral finance specializes in the area of ​​how gender influences investor behavior, particularly among women.

She believes it’s nearly impossible to avoid the emotional biases that govern financial decisions. The key, she says, is an individualized approach. She has discovered that by focusing on creating unique portfolios based on the personality and goals of investors, one can “adapt the biases” that individuals may have.

Experts identify a few key patterns of behavior when studying behavioral finance as a whole:

Conservatism bias

Can manifest in many ways, but the key behavior is to stick with information you are comfortable with. This can be by relying too heavily on existing data rather than new data, or by sticking only to markets you know well, such as investing only in national markets.

too much confidence

Overconfidence in one’s abilities, such as neglecting to rely on data. It’s like subconsciously believing that your experience and track record will give you a substantial head start over other investors. Salem says she often sees this behavior in young investors who may also have family members in the financial field.

Herd behavior

When individuals follow the trends of a group rather than relying on their own research and intuition, it can lead to investment bubbles, which in turn can lead to stock market crashes. A recent example of herding behavior, Salem says, was the January 2021 GameStop mania.

In this case, Reddit page r/WallStreetBets urged followers to buy and hold shares of troubled GameStop in a bid to retaliate against Wall Street hedge funds that had planned to short the stock, resulting in a short squeeze. The collective behavior of many who jumped on the trend sent the stock skyrocketing to a high of $483.00, a 1,500% increase from its previous price.

Confirmation bias

It is the tendency to rely on information that supports a specific set of beliefs. In finance, this could lead to favoring data that reinforces a specific opinion, such as ownership of a stock in a particular sector will outperform others.

As well as identifying biases as a whole, experts also look at trends that may be specific to a particular group, whether it’s age, gender or ethnicity.

Joshua Dietch, vice president of retirement thought leadership at T. Rowe Price, specializes in analyzing this data, particularly the influence of behavioral finance on saving for retirement.

When it comes to younger investors, he notes two factors that influence investment choices: experience with past stock market crashes and use of technology, especially social media and other apps to transact. .

Those who saw their portfolios collapse in the stock market crash of 2008 and 2009 are a bit more apprehensive about risky investments, he notes.

“Those who probably haven’t really experienced an extended market downturn are treating it more like gambling,” Deitch says.

“On the other hand, some of the things we’ve seen, in relation to the quasi-‘gamification’ of investing, can be just as harmful because they’re not based on a long-term perspective,” he says. .

In his view, it is vital for young investors to consider the long-term implications, particularly when saving for retirement, as funds will not be available for some time. However, he points out, now is also the time to invest in more volatile markets, as there is more time to “catch up” if those assets are not performing well.

“The proximity of needs is a determining factor.”

Gender influences investment

Experts seem to agree that there are innate behavioral differences between men and women when it comes to making financial decisions.

Studies show that women as a whole tend to be less risk averse than men. While this can be beneficial when it comes to making safer investments, it can also get in the way of making gains, especially for young women.

As mentioned earlier, young investors should be willing to take moderate risk when it comes to saving for long-term goals, such as retirement. Women also tend to live longer, so in theory there are more opportunities to make up for losses if a riskier investment goes wrong.

They also focus more on preserving wealth, while men focus on accumulating wealth. Salem says this pattern often manifests as endowment bias, which is the tendency to place a higher value on an asset because it belongs to oneself. She especially sees this when assets are inherited from a family member, such as stocks. She notes that women tend to hold on to these shares because of their sentimental value as “legacy” rather than making their own financial decisions with said assets.

The men aren’t off the hook, however. While women tend to be less confident with investments, men are overconfident. They tend to trade more and therefore be more financially active. Studies have shown that when men are placed in fund management groups, investments tend to be riskier. This isn’t necessarily a good thing – once transaction costs and fees are factored in, men actually have lower net returns than women when it comes to personal finance.

Perhaps due to lower levels of trust, women are generally more open to receiving advice from financial professionals, but are “paradoxically underserved,” according to Dietch.

However, Salem believes that the reserved behavior of women could have positive effects on the financial world, if more had access to high-level positions. The world of finance is still a very male-dominated field, so advocates such as Salem urge others to identify female role models not as shortcomings, but rather as assets to a group.

“Having more women in the stock market with their more rational thinking would really make the stock market less volatile,” she says. Study results have supported the claim that a more diverse workforce produces better returns.

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