Behavioral biases that can harm your investment portfolio
Whether it is to our detriment or to our advantage, we are human. Our impulsive and emotional nature governs the way we make decisions. Rational choices are often clouded by irrational emotions. It really comes down to our DNA – our tendency to follow certain patterns of behavior is part of our psychology as human beings. However, when financial choices are influenced by our DNA’s survival mechanisms, our returns can suffer. Conversely, understanding psychological patterns can also work to our advantage. In essence, what if predicting unpredictable humans was possible?
Enter the study of behavioral finance, or how psychology affects the behavior of investors and financial analysts.
“Behavioral finance includes psychology, finance, economics and sociology to understand investor behavior and the behavior of the market as a whole,” says expert Razan Salem, professor of behavioral finance at Northeastern University as well as ‘an investment and financial consultant. .
Salem’s research in behavioral finance specializes in the area of gender influence on investor behavior, particularly among women.
She thinks it’s almost impossible to avoid the emotional biases that govern financial decisions. The key, she says, is an individualized approach. She has found that a focus on creating unique portfolios based on both the personality and goals of investors can “tailor any biases” that individuals may have.
Experts identify a few main patterns of behavior when studying behavioral finance as a whole:
Can manifest itself in many ways, but the key behavior is to stick to information that 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 domestic markets.
Placing too much faith in one’s abilities, such as neglecting to trust data. It is like subconsciously believing that his experience and background will give him a 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.
When individuals follow the trends of a group rather than relying on their own research and hunches, it can lead to investment bubbles which, in turn, can lead to stock market crashes. A recent example of herd behavior, according to Salem, was the GameStop mania of January 2021.
In this case, Reddit page r / WallStreetBets urged subscribers to buy and hold struggling GameStop stock in a bid to retaliate against Wall Street hedge funds that had planned to short-sell the stock, resulting in a short squeeze. The collective behavior of many of those who jumped the trend caused the stock to skyrocket to a high of $ 483.00, a 1,500% increase from its previous price.
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 one industry will outperform others.
In addition to identifying prejudices as a whole, experts also look at trends that may be specific to a particular group, be it age, gender or ethnicity.
Joshua Dietch, vice president of thought leadership in retirement at T. Rowe Price, specializes in analyzing this data, particularly the influence of behavioral finance on retirement savings.
When it comes to young investors, he notices two factors influencing investment choices: the experience of previous stock market crashes and the use of technology, especially social media and other apps to transact.
Those who had depressed portfolios during the stock market crash of 2008 and 2009 are a little more afraid of risky investments, he notes.
“Those who probably haven’t really experienced a prolonged market downturn are treating it more like gambling,” Deitch explains.
“On the flip side, some of the things we’ve seen, in relation to the quasi-gamification of investing, can be just as damaging 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, especially when saving for retirement, as funds will not be available for some time. However, he points out, this 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 the need 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 averse to risk than men. While this can be beneficial when it comes to making safer investments, it can also hamper earning gains, especially for young women.
As mentioned earlier, young investors should be willing to take moderate risks when it comes to saving for long-term goals, like retirement. Women also tend to live longer, so in theory there is more scope for offsetting losses if a riskier investment goes awry.
They also focus more on preserving wealth, while men focus on accumulating wealth. Salem says this pattern often manifests itself in endowment bias, which is the tendency to place a higher value on an asset because it belongs to you. She sees this especially when assets are inherited from a family member, like stocks. She notes that women tend to hold onto these stocks because of their sentimental value as being “inherited” rather than making their own financial decisions with these assets.
The men are not off the hook, however. While women tend to be less confident in investments, men are overconfident. They tend to trade more, thus being more financially active. Studies have actually 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 “ironically underserved,” according to Dietch.
However, Salem believes that the reserved behavior of women could have positive effects on the financial world, if more were given access to high-level positions. The world of finance is still a very male-dominated field, so advocates like Salem urge others to identify female behaviors not as shortcomings, but rather as strengths for a group.
“Having more women in the stock market with their more rational thinking would really make the stock market less volatile,” she says. Research findings have supported the claim that a more diverse workforce produces better returns.