Are your investment decisions primarily rooted in logic and facts, or are emotions and flawed reasoning influencing your choices?
We’re only human, after all—biases are bound to arise. However, market participants must be aware of bias as they navigate investment decisions. By definition, bias refers to systematic deviations from rational judgment or objective decision-making, often influenced by emotions or cognitive limitations.
The result: Inaccurate processing of information. In other words, biases could negatively impact your portfolio. Learn how and discover different types of biases below.
What Can Investor Bias Look Like?
Financial markets, notably the stock market, function as information-processing mechanisms. They serve as systems that aggregate and interpret information, from macroeconomic to industry/firm-specific, which translates to market prices.
Decision-makers include both human participants (i.e., retail/institutional investors) and non-human actors (e.g., algorithmic and high-frequency traders) who make buy/sell decisions daily, influencing price discovery. Thanks to the human element, financial markets are inevitably subject to bias and irrational behaviors, often leading to price distortions that diverge from fundamental value.
Investor biases can generally be broken into two categories: emotional bias and cognitive errors. Emotional biases are not related to conscious thought but stem from feelings, impulses, and intuition. Cognitive errors typically involve flawed reasoning. Some common examples of each include:
- Loss aversion bias: Disliking losses more than gains
- Overconfidence bias: Overestimation of one’s skill/predictive ability
- Regret aversion bias: Tendency to choose the option that carries the lowest potential for regret
- Conservatism bias: Clinging to prior views and underreacting to new information
- Confirmation bias: Seeking out information that supports preexisting beliefs
- Illusion of control: Believing you can control outcomes that you cannot
- Availability bias: Overestimating the importance of readily available or recent information
How Can Investor Bias Impact Markets?
The existence of bias in investment decision-making can lead to a few common market outcomes that we see time and time again, such as:
- Asset bubbles and market crashes (e.g., the dot-com bubble of ’99 and the housing crash of ’08)
- Excessive market volatility and overreaction to news
- Market anomalies (e.g., the momentum effect, in which recent winners continue to rise)
How Could Investor Bias Impact My Portfolio?
For individual investors, allowing biases to influence decision-making can lead to suboptimal portfolio construction and diminished long-term returns.
Understanding and recognizing these biases can help investors make more rational, disciplined, and objective decisions. While biases can’t be eliminated, they can be managed effectively through self-awareness and structured investment strategies.
Using a programmed 401(k) or considering a professionally managed account can help you stick to a disciplined process. And if you need guidance in this area, Carlson Investments can help! Speak to an advisor today to ensure you’re building a portfolio that works for you and your goals.
Carlson Investments does not provide tax, legal, or accounting advice. This content has been written for informational purposes only. Always consult your individual tax, legal, or financial professionals for advice tailored to your situation.
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