How Biases Affect Investor Behavior via SSRN

H. Kent Baker

American University – Kogod School of Business

Victor Ricciardi

Goucher College – Department of Business Management

How Biases Affect Investor Behavior

Investor behavior often deviates from logic and reason, and investors display many behavior biases that influence their investment decision-making processes. Below, H. Kent Baker and Victor Ricciardi describe some common behavioral biases and suggest how to mitigate them.

“The investor’s chief problem – even his worst enemy – is likely to be himself.” – Benjamin Graham

Why do investors behave as they do? Investor behavior often deviates from logic and reason.

Emotional processes, mental mistakes, and individual personality traits complicate investment decisions. Thus, investing is more than just analysing numbers and making decisions to buy and sell various assets and securities. A large part of investing involves individual behavior. Ignoring or failing to grasp this concept can have a detrimental influence on portfolio performance.

Behavioral biases in investing encompass many types. For example, cognitive biases refer to tendencies to think and act in certain ways. A cognitive bias can be viewed as a rule of thumb or heuristic, which can lead to systematic deviations from a standard of rationality or good judgment. Some controversy still exists about whether some of these biases are truly irrational or whether they result in useful attitudes or behavior. Other biases are more emotional in nature. An emotional bias is one that results in taking action based on feelings instead of facts. Given that some overlap exists between cognitive and emotional biases, we simply call them behavioral biases. An important aspect of avoiding such biases is to become aware of them. Thus, by avoiding behavioral biases investors can more readily reach impartial decisions based on available data and logical processes.

Our purpose is to briefly discuss investor behavior, review eight common behavioral biases, and then concentrate on two types of investors – overconfident investors and status quo investors. Baker and Nofsinger (2002, 2010) and Baker and Ricciardi (2014) provide more detailed discussions of investor behavior including behavioral biases.

Investor Behavior

What is investor behavior? The field of investor behavior attempts to understand and explain decisions by combining the topics of psychology and investing on a micro level (i.e., the decision process of individuals and groups) and a macro level (i.e., the role of financial markets). The decision-making process of investors incorporates both a quantitative (objective) and qualitative (subjective) aspect that is based on the features of the investment product or financial service. Investor behaviour examines the mental processes and emotional issues that individuals, financial experts, and traders reveal during the financial planning and investment management process. In practice, individuals make judgments and decisions that are based on past events, personal beliefs, and preferences. They establish short cuts or heuristics that can save time but lead them away from rational, long-term thinking.

By avoiding behavioral biases investors can more readily reach impartial decisions based on available data and logical processes.

Understanding investor behavior can inform investors about these biases and help them improve their decision making processes in selecting investment services, products, and strategies. As a result of the financial crisis of 2007-2008, the discipline of psychology began to focus even more on the financial decision-making processes of individuals. This renewed interest by the social sciences and business disciplines has spurred new research on investor behavior.

Common Behavioral Biases

Investors exhibit many biases. Few of these behavioral biases exist in isolation because deep interactions exist among different biases. Nonetheless, the following list represents some common biases facing investors but others may be equally important depending on the specific situation. Baker and Nofsinger (2002), Ricciardi (2008), iShares (2013), Parker (2013), and Seawright (2012) provide further discussion of behavioral biases and how to deal with them.