Humans can be irrational beings, and nowhere is this irrationality more on display than in investing. There’s a whole field of psychology dedicated to the subject. Traditional economic theory says that people make rational decisions, but the relatively new field of behavioral economics says that rational behavior goes out the door when it comes to investing.
Behavioral economics combines elements of economics and psychology to understand how and why people behave the way they do in the investing world. Behavioral economics starts with the premise that investors are irrational and make investment decisions based on factors that have nothing to do with well-informed decision-making.
The proof is all around us in the form of herding behavior in the markets and the continual appearance of investment bubbles throughout history that have devastated portfolios in the wake of these bubbles bursting.
It’s irrational behavior that leads to bubbles and massive investment losses. In the absence of bubbles, even on a day-to-day basis, irrational behavior leads to speculative behavior that is akin to gambling. With gambling, we all know the house wins every time.
In his book, Misbehaving: The Making of Behavioral Economics, Richard H. Thaler traces the development of behavioral economics and explains how irrational investor behavior is often driven by behavioral biases that lead to bad decision-making. However, by understanding these biases, investors can learn to avoid them or compensate for them to make more rational investment decisions.
So, what behavioral biases/investment misbehaviors can investors recognize and learn to avoid in their own investment activities?
Perception Bias: The perception bias drives the price of an asset more than its actual and practical value. The perception of value is a bigger driver of price than the actual value. Perception is how crypto and meme stocks reached astronomical heights in 2021, during the stimulus-induced investing frenzy that saw investors snatching up crypto and worthless stocks on the perceived value of these assets based purely on the speculation that investors would pay more for them down the road. What people are willing to pay depends more on perception than the actual worth of the asset.
Loss Aversion: People have an aversion to losses. The fear of loss is usually greater than the joy of gain. As a result, they tend to make irrational decisions. Investors playing into the loss aversion bias buy into the traditional risk-return tradeoff that says high returns can only come from high risk. The problem with loss aversion is it causes some investors to be too risk-averse. It prevents them from considering alternative investments that may not follow the traditional risk-return paradigm that can deliver higher risk-adjusted returns than traditional investment assets.
Herd Behavior. This bias is probably the most common behavioral investing bias, and it goes hand in hand with the fear of missing out. Herd behavior says investors will make decisions according to what the herd does not only because they think it’s comfortable or safe but also because they don’t want to face the shame of missing out. The problem is herd behavior has been the root cause of every investment bubble that has ever existed.
Availability Bias. Availability bias says investors go with what’s convenient and easy. They’ll take everyone else’s word at face value on investment instead of doing their own research. They will make decisions based on what’s convenient and immediately grabs their attention – whether it be social media; the internet; their friends, neighbors, and colleagues; or anything else showing up on their phone screens.
Status Quo Bias: Status quo bias says investors will stick to what’s familiar, traditional, well-known, or common. They are unwilling to try anything new.
We’ve all been guilty of behavioral biases that have led to less-than-desirable investment results and returns in our portfolios. Successful investors have been the ones that recognize this bias and either has trained themselves to overcome these biases or put their portfolios in a position to buffer the impact of these biases by taking human error out of the equation.
What Smart Investors Do to Avoid Investing Misbehavior
So what do smart investors do to overcome behavioral biases to combat irrational investment behavior? Education.
Investors who educate themselves and open their portfolios to investment possibilities outside of Wall Street give themselves the best chances for bucking investment misbehavior and winning the investment game.
Taking the first step of educating themselves and exploring alternative investments allows smart investors to avoid multiple biases, such as the status quo bias, availability bias, and loss aversion biases, right out of the gates. Then, once opportunities arise, investors can avoid perception bias by doing their homework and doing their due diligence to evaluate deals based on the actual value, not the perceived value.
Finally, smart investors deal with herd behavior by taking it completely out of the equation. By investing in the illiquid private markets with long lockup periods, these investors take the herd out of the equation altogether with no effort required of themselves. These illiquid investments would prevent investors from acting on their impulses even if they wanted to. Either way, herd behavior does not affect a private investor’s investment decision-making.
Do you want to become a successful investor?
Then become rational by avoiding the behavioral biases/investing misbehaviors plaguing the average investor.
