Market psychology: What is behavioral finance, and how can it affect your investing decisions?

When it comes to investing, you like to think you’re a rational human being, making level-headed decisions that are in your best interest. The problem is that investing is a challenging activity, and sometimes your brain gets in the way.

Market changes and economic uncertainties can trigger emotions and knee-jerk reactions that derail your best-laid plans. Unfortunately, it’s all part of being human. Understanding the “why” behind these tendencies—a practice known as behavioral finance—can help you to address them.

What is behavioral finance?

During the 1970s, psychologists Daniel Kahneman and Amos Tversky studied what they called behavioral finance, which merges psychology and finance to understand why and how people make financial decisions. Their research found that most people are subject to unconscious cognitive biases that cloud their judgment and drive irrational choices.

“Kahneman and Tversky discovered that the human mind has two general decision-making responses,” says Eric Freedman, chief investment officer at U.S. Bank. “The first is fast response, where the mind makes a quick decision by going to information that is readily available. The second is the slow decision, which involves thoughtful cognition. With investing, the fast response and the slow decision are in complete conflict.”

Three categories of behavioral finance biases that affect investing

Biases can affect investing in a variety of ways, and investors often don’t realize they’re at work. Awareness of these common biases can help you shift your mindset to make better decisions in the moment.

Cognitive biases

Cognitive biases happen when the brain’s ability to think and reason don’t comply with the principles of logic. There are two types of cognitive bias that are of particular relevance to investing.

• Availability bias is one of the most prevalent cognitive biases around finances. This bias taps into the brain’s fast twitch reaction, causing it to immediately jump to what was most recently observed or experienced. For example, you may feel more confident and willing to take on greater risk during a market rally. Or you may avoid a certain stock if you previously held it in your portfolio and experienced a loss, even if new facts or the news cycle may change the company’s outlook. “Investors tend to give too much weight to recent events or experiences,” says Freedman. “Investing involves multilayer dimensionality, and that can be easily lost.”
• Confirmation bias is the term for when humans instinctively filter out information that doesn’t fit their preconceived notions and put more weight on thoughts or news that aligns with the beliefs they’ve already established. Perhaps you’re interested in a certain stock and start doing research before making an investment decision. While doing your due diligence, you find 10 reports, six of which are bullish and four of which are bearish. “You may dismiss the bearish ones because you just want reinforcements of what you’re already thinking,” says Freedman.

Emotional biases

Investing is often emotional, as it’s tied to dreams and plans for the future. Unfortunately, emotions can also create biases that lead to financial errors. Let’s review two types of emotional biases that can occur when investing.

• Loss aversion. It’s no surprise that most people would prefer gains over losses in their investments, but losses create stronger emotional reactions. A study published in The Quarterly of Journal Economics found that investors feel 2.5 times as bad about a $1 loss as they feel good about a $1 gain. Loss-aversion bias often prompts investors to sell well-performing investments too soon. “When you see you’re losing money, you want to stop immediately,” Freedman says. “It’s a primal response. As investors, we need to figure out if we’re making decisions based on our cognitive biases.”
• Anticipated regret. This is when we imagine the regret we may experience in the future, affecting our current investment decisions. For example, you may hear of an up-and-coming company that seems like it has great prospects for the future. Anticipated regret could result in you investing without doing your due diligence for fear of missing out on big returns in the future. On the other hand, anticipated regret could also manifest itself if you chose not to invest because you didn’t want to lose money if the company ended up failing.

Social biases

The final type of bias that affects financial behaviors is social bias. This is when we act or reach decisions in response to the people around us. One type of social bias to remember when investing is groupthink.

“What happens with groupthink is that people default to either the most senior person or the person who talks the most,” says Freedman. “That's not always the best way to make decisions.”

Groupthink can affect your investing if you talk with friends and family about your stock picks, for example. Their input can influence your behavior. Watching financial news shows on television can be another form of groupthink. It can be tempting to follow the advice of investing “experts” without doing your own due diligence and investing based on what’s right for your investing horizon and risk tolerance.

Strategies for avoiding behavioral finance biases in investing

Instead of falling for biases that could lead to poor decisions, Freedman suggests adopting strategies that can help you determine whether facts or behavioral finance biases are informing your thinking.

Start by asking yourself, “Am I making a decision when my emotional state is amplified?” People often make an adverse decision during a times of heightened stress, such as bereavement, a job change or a big geographical move.

It’s also important to consider your time horizon. “In the diversified portfolio, not everything will be working at the same time,” says Freedman. “Investors sometimes respond emotionally to an unrealized loss, wanting to get it off their screen. This can drive a behavioral response.”

Keep yourself from checking your statements or account balances all the time, which can trigger biases and drive bad decision making. Instead, have a plan that’s in sync with your time horizon and your risk tolerance.

Fighting behavioral finance biases with expert help

Working with a financial advisor and developing a comprehensive financial plan can help you manage your potential behavioral finance biases. For example, a plan can remove availability and groupthink biases by keeping you focused on long-term goals instead of reacting to current market events or making changes to your portfolio based on a layman’s opinion.

A trusted advisor working alongside you to create a plan also removes confirmation bias and anticipated regret by tapping into an educated and objective perspective that broadens your knowledge base. And advisors can help investors avoid loss aversion by helping them time entrances and exits from the market based on goals instead of volatility.

Remember, investing can be challenging, but it isn't a fight-or-flight activity. “All investors have tendencies to make decisions based on emotion,” says Freedman. “Awareness is key, and putting sound practices in place is essential.”

Learn how our team-based planning approach can help you review your investment and financial opportunities from all perspectives.