Retirement Daily's assistant editor Hannah Sammut explains what you need to know about the behavioral biases that can adversely affect your investment portfolio.
Whether it be to our detriment or benefit, we're human. Our impulsive and emotionally-driven nature governs the way we make decisions. Rational choices are often muddled by irrational emotions. It really boils down to our DNA-our tendency to follow certain behavioral patterns is part of our psychology as human beings. When financial choices are influenced by the survival mechanisms in our DNA, however, our returns may suffer. Conversely, understanding psychological patterns can also work to our advantage. In essence, what if predicting unpredictable humans was possible?
Enter the study of behavioral finance, or how psychology impacts the behavior of investors and financial analysts.
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"Behavioral finance includes psychology, finance, economy, and sociology all together to understand how investors behave and how the market as a whole behaves," says expert Razan Salem, a lecturer of behavioral finance at Northeastern University as well as an investment and financial consultant.
Salem's research in behavioral finance specializes in the area of how gender influences investor behavior, specifically in women.
She believes it's near impossible to avoid the emotional biases that govern financial decisions. The key, she says, is in an individualized approach. She's found that a focus on creating unique portfolios according to both investors' personalities and objectives can "adapt the biases" individuals may hold.
Experts identify a few main patterns of behavior when studying behavioral finance as a whole:
Conservatism bias
Can be manifested in many ways, but the key behavior is sticking to information one is comfortable with. This can be by relying too heavily on existing data rather than new data, or by only sticking to markets that one knows well, such as solely investing in domestic markets.
Overconfidence
Placing too much faith in ones' abilities, such as neglecting to rely on data. It boils down to unconsciously believing that one's experience and background will give a substantial leg up compared to other investors. Salem says she sees this behavior often in younger investors who may also have family members in the financial field.
Herd behavior
When individuals follow the trends of a group rather than relying on their own research and intuition it can result in investment bubbles, which in turn, can result in market crashes. A recent textbook example of herd behavior, Salem says, was the GameStop mania of January 2021.
In this instance, Reddit page r/WallStreetBets urged followers to buy and hold stock of struggling GameStop in an effort to retaliate against Wall Street hedge funds that had planned to short the stock, thus resulting in a short squeeze. The collective behavior of many who hopped on the trend made the stock skyrocket to a high of $483.00, a 1,500% increase from its prior price.
Confirmation bias
This is the tendency to rely on information that supports a specific set of beliefs. In finance, this could lead to favoring data that reinforces a specific opinion, such as that ownership of a stock in a particular sector will outperform others.
In addition to identifying biases as a whole, experts also look at trends that may be specific to a particular group, whether it be age, gender, or ethnic background.
Joshua Dietch, vice president of retirement thought leadership at T. Rowe Price, specializes in analyzing such data, specifically how behavioral finance influences saving for retirement.
As it relates to young investors, he notices two factors that influence investment choices: experience regarding prior market crashes and use of technology, specifically social media and other apps to make trades.
Those who have experienced tanking portfolios during the stock market crash of 2008 and 2009 are a little more apprehensive of risky investments, he notes.
"Those that probably haven't really experienced a prolonged market downturn treat it more like gambling," Deitch says.
"On the other hand, some of the things that we've seen, relative to almost the 'gamification' of investing, can be equally as harmful because it isn't predicated on a long-term outlook," he says.
In his opinion, looking at long-term implications is vital for young investors, especially when saving for retirement, as funds won't be accessed for some time. However, he stresses, this is also the time to make investments in more volatile markets as well, as there is more time to "catch up" if those assets don't perform well.
"Proximity to need is a big determinant."
Experts seem to agree that there are innate behavioral differences among men and women when it comes to making financial decisions.
Studies show that women as a whole tend to be less risk-averse than men. While this can be beneficial when it comes to making safer investments, it can also hinder making gains, specifically for younger women.
As mentioned earlier, younger investors should be open to taking moderate risk when it comes to saving for long-term goals, such as retirement. Women also tend to live longer, so in theory, there is more opportunity to make up for losses should a riskier investment go awry.
They also focus more on wealth preservation, while men focus on wealth accumulation. Salem says this pattern often manifests itself in endowment bias, which is the tendency to place a higher value on an asset because it is owned by oneself. She sees this specifically when assets are inherited from a family member, such as stocks. She notes that women tend to hold on to such stocks due to their sentimental value as being "inherited" rather than making their own financial decisions with said assets.
Men aren't off the hook, though. While women tend to be less confident with investments, men are overconfident. They tend to trade more, thus being more financially active. Studies have actually shown that when men are placed in fund management groups, investments tend to be riskier. This isn't necessarily a good thing-once transaction costs and fees are considered, men actually have lower net returns than women when it comes to personal finance.
Perhaps due to lower levels of confidence, women are typically more open to receiving advice from financial professionals, but are "paradoxically underserved", according to Dietch.
However, Salem believes that the reserved behavior of women could have positive effects to the financial world, if more had access to high-level positions. The world of finance is still a very male-dominated domain, so advocates such as Salem urge others to identify female behavioral patterns not as shortcomings, but rather as assets to a group.
"Having more women in the stock market with their more rational thinking would really make the stock market less volatile," she says. Results from studies have supported the claim that more diverse workforces yield better returns.