How to Avoid Biases & Common Mistakes as an Investor

Do you find yourself in a panic about your investments after watching the evening news? Or are you suddenly second guessing your portfolio after a conversation with a colleague who seems to know what the best stocks to invest in are?

Although investing should be based in research, data, and the academic work of those like Eugene Fama and Kenneth French - investors tend to make decisions based on emotions like fear, comfortability, and greed instead. Why is this? It is because your investments are sourced from your hard-earned savings, they represent years of sacrifice, and provide a sense of hope and security for you and your loved ones. It is no wonder some of the most common mistakes made by investors are behavioral. The good news is you can avoid these mistakes by learning how to recognize the biases that lead to these behaviors.

Let’s work through some of these biases together.

One of the most common biases in investing is familiarity bias. Investors tend to invest in what they know – to put it simply. In your portfolio, this may mean holding only domestic stocks, investing in your employer’s company stock, or only investing in companies whose products you use. This type of behavioral bias can increase your concentration risk and can negatively impact your portfolio over the long run.

Here is an example – let’s say John Smith owns a home in Seattle, he works for Amazon, his wife, Jane, works for Microsoft and they both have most of their 401ks invested in their respective employer’s company stock. This means all their income, real estate and investments are geographically concentrated not only in the US but in the greater Seattle area. With an excess amount of company stock, not only is their income already dependent on the success of those companies, but their savings and investments are as well. So why do people do this? Because the familiarity bias provides a false sense of security and overconfidence in the future of their investments.

Another incredibly influential bias is media bias.  Sensational headlines, negative news and scare tactics can affect investors decisions and ultimately hinder their long-term goals. It important to remember that media is, at the end of the day, a business and is built to profit off the fears of viewers. The best thing you can do for your portfolio is to know the historical research and trends in the market.

The market has weathered wars, depressions, recessions, elections, and much more and has continued to trend upwards. Try to take everything on the news with a grain of salt. Don’t let the media overshadow the facts. A healthy level of realistic optimism is crucial to being successful with investing.

Another form of behavioral bias impacting investors is confirmation bias. Investors tend to seek out information that already confirms existing beliefs. This has been amplified with social media - algorithms and catered online preferences narrow the information you are exposed to daily. Do your best to seek out different viewpoints and reputable sources whenever you can, but especially when it comes to investment or financial advice.

The best way to ensure you do not fall prey to the biases discussed in this article and ultimately are able to attain your long-term financial goals is to create a comprehensive financial plan for your future and build your portfolio around that – this will give you the guardrails to stay on track with your investments. 

Sources:

https://www.dimensional.com/us-en/insights/market-returns-through-a-century-of-recessions
https://library.uco.edu/misinformation/mediabias
https://www.sciencedirect.com/science/article/abs/pii/S1386418117301155
https://www.schwabassetmanagement.com/content/confirmation-bias
http://bogan.dyson.cornell.edu/doc/Hartford/Bogan-6_Familiarity.pdf

Disclosures:

Apella Capital, LLC (“Apella”), DBA Apella Wealth is an investment advisory firm registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered or excluded or exempt from registration requirements. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Apella Wealth provides this communication as a matter of general information. Any data or statistics quoted are from sources believed to be reliable but cannot be guaranteed or warranted.