Eliminating all biases when investing is nearly impossible. Financial markets are a prime example of the way human biases can manifest at either end of a spectrum of emotions: This is the core of behavioral finance, where the study of economics and psychology intersect.
People don’t always make rational decisions when it comes to money. In fact, they usually do the opposite. However, most of us cannot afford to make mistakes with our retirement money. To secure your retirement, you should avoid these four common investing biases that often lead investors to make mistakes.
1. Hot-hand fallacy. This is the notion that because one has had a string of success, he or she is more likely to have continued success. For example, one study found that casino gamblers “bet more after winning because they believed that their chance of winning again was greater than before.”
This also happens in financial markets, as investors make decisions based only upon recent information compared to all of the available data, which can often lead to thinking current trends are the best predictors of what will happen next.
According to an Investopedia article on behavioral finance, “researchers on behavioral finance found that 39 percent of all new money committed to mutual funds went into the 10 percent of funds with the best performance the prior year. Although financial products often include the disclaimer that ‘past performance is not indicative of future results,’ retail traders still believe they can predict the future by studying the past.”
2. Regret aversion. Some investors make decisions in a way that allows them to avoid feeling emotional pain in the event of an adverse outcome. This bias motivates people based on two powerful emotions, fear and greed. The theory of regret aversion or anticipated regret proposes that when facing a decision, individuals might anticipate regret and thus incorporate in their choice their desire to eliminate or reduce this possibility.
For example, an investor who fell victim to the dot-com bubble or 2008 financial crisis and sold their equity positions at the absolute worst time would feel anticipated regret if they were to think about reinvesting in the stock market again.