An article in CNBC.com offers an overview of seven cognitive biases that can significantly impact investor decision-making.
“Given the foundational level at which these biases exist,” the article contends, “they have the capacity to affect practically all decisions, but can have an especially profound impact on financial planning and investment choices:”
- Overconfidence bias—having an “inflated view of one’s own decision-making abilities.” This can lead investors to make “wrong-headed—and ultimately harmful—investment decisions.”
- Confirmation bias—can prompt investors to prioritize information about an investment that agrees with an existing ideas and beliefs “over information that does not so agree.”
- Familiarity bias—is based in the concept that people tend to draw greater comfort and confidence from familiar things and people. However, the article notes that it can lead investors to “perpetually gravitate toward markets and vehicles well-known to them, at the expense of less-familiar options that may nevertheless be superior.”
- Endowment effect—refers to “the behavior or ascribing greater value to something simply because you already own it.” This is evident when an investor is enticed to hang onto a stock or fund “long after objective analysis advises selling it.”
- Loss-aversion bias—the tendency to make decisions to avoid loss. “Loss aversion can emotionally leverage an individual into an unwillingness to accept losses and move on to a more productive alternative.” For example, if an investor is unwilling to sell a security that has lost value even when other holdings are performing well.
- Anchoring bias—involves staying focused on a specific piece of information and “evaluating how to proceed exclusively in terms of that information. One example the article offers is that of an investor refusing to sell an underperforming stock until the price returns to at least the level they paid for it.
- Herd behavior—”going along with the crowd” is a human tendency, but in investing it can lead to a stock becoming “all the rage” and ultimately overpriced. “On a larger scale,” the article says, “this phenomenon can occur with entire markets,” citing the dot-com bubble of the early 2000s.
In investing, the article concludes, these tendencies can have a significant impact– and while it notes that there is not foolproof way to guard against them, being aware that they exist is a “good start.”