Understanding Behavioral Bias

Learning how emotions affect decisions can make you a better investor

Are you a better-than-average driver? Chances are, you answered yes. That’s because nearly three-quarters of people think they are better-than-average drivers. 1 Besides being mathematically impossible, this statistic is an example of overconfidence—and is just one illustration of how certain biases can influence our thought patterns. 

These behavioral biases sometimes help us make smart decisions. But they also can cloud our judgment and lead us to make irrational decisions. That’s especially true when it comes to investing. At a time when markets are down and it’s impossible to predict what tomorrow will look like, our perceptual distortions can make a difficult situation worse. 

The good news is recent evidence suggests that we can learn to overcome these biases and improve our decision-making. But first we have to understand how they work. Here’s a look at three of the most common behavioral biases that can impair our investment decisions.

Anchoring

You’ve fallen victim to anchoring when your emotional attachment to the past value of an investment keeps you from recognizing its present value. For example, let’s say you own stock that was recently selling for $100 per share but has since dropped to $60. But you may be anchored to that $100 figure, convinced that’s the right value for that stock. As a result, you may hold onto your stock convinced it will soon rebound. However, there’s no guarantee that it will.

When assessing your investments, ask yourself whether your evaluations are based on the current reality of the assets or your past feelings about them. Weigh the merits of keeping an investment based on current information and whether it’s still a good fit for your financial plan. 

Recency bias

Recency bias can lead to putting too much emphasis on the latest information—and often ignoring other important data. For example, say stocks begin to climb and that uptick inspires a surge in buying. As more investors pile on, prices climb even higher, surpassing historically expensive levels. Yet investors may ignore this red flag, assuming recent trends outweigh long-term data. However, bubbles like these can pop and falling prices can potentially leave investors with heavy losses. 

You can avoid recency bias by taking a long-term approach to investing. Strategies such as dollar-cost averaging, when you make a series of regular investments regardless of the market’s ups and downs, can help erase the temptation to chase returns or panic when prices fall. 

Overconfidence

Confidence is useful and, in many cases, necessary. Investing a chunk of your income in the stock market takes confidence. And it’s confidence that allows you to keep risks in perspective and sit tight in a turbulent market rather than rushing to sell your assets and locking in losses. 

But overconfidence can be dangerous. It can lead you to believe that you know better than experts, that you can predict market movements successfully (spoiler: you can’t), or that you can spot investment opportunities others have missed. Worst of all, it can lead to emotional decisions in response to market moves, such as buying when prices are high and selling when prices are low. 

Combat a tendency toward overconfidence by basing investment decisions not on emotion, but on careful research. Once you’ve made a decision, stick with it and avoid the temptation to try to outsmart the market by jumping in and out of investments.   

Recognizing how behavioral biases influence investing can help you keep them in check. As a result, you’ll be more likely to make investment decisions that align with your long-term financial plan—and to avoid the irrational decisions that may knock you off track from that plan.  

1 AAA, “More Americans willing to ride in self-driving cars,” 2018.

Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results.

This letter is not intended to be relied upon as forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date noted and may change as subsequent conditions vary. The information and opinions contained in this letter are derived from proprietary and nonproprietary sources deemed by Roush Investments, LLC to be reliable. The letter may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projection and forecasts. There is no guarantee that any forecast made will materialize. Reliance upon information in this letter is at the sole discretion of the reader.

Please consult with a Roush Investments, LLC financial advisor to ensure that any contemplated transaction in any securities or investment strategy mentioned in this letter align with your overall investment goals, objectives, and tolerance for risk.

Additional information about Roush Investments, LLC is available in its current disclosure documents, Form ADV and Form ADV Part 2A Brochure which are accessible online via the SEC’s investment Adviser Public Disclosure (IAPD) database at www.adviserinfo.sec.gov, using SEC # 151288.

Roush Investments, LLC is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.