Here are some of the more common behaviors that can lead to irrational decisions:
This occurs when people look for information that confirms their beliefs rather than the information that might disprove them. Before making a reasoned decision, a trader or investor should consciously look for disproving evidence.
We can wrongly project that probabilities will revert to long-term averages. Here’s an example: A coin flip has produced 5 heads in a row. We project that tails is the most likely outcome of the sixth flip. This is incorrect. The odds remain 50/50.
This occurs when we give greater weight to information about a security that is more accessible or readily recalled. Traders and investors should take a step back and look at the big picture, rather than making a decision based on what’s currently happening.
We can have an emotional aversion to taking a loss in a security even when doing so might be the best decision. On the other side, we can tend to sell winners simply because they have made profits, possibly missing out on future gains.
Similar biases are prevalent among traders and investors as well. According to Dalbar Inc., a financial services market research firm, behavioral biases have led to poor portfolio decisions.
According to a Dalbar study, the average stock fund investor recorded a 4.67% return over a 20-year period (1996-2015) compared with the 8.19% increase in the S&P 500 over the same period. The difference largely comes because investors jumped in and out of the funds at the wrong time. Many panicked and sold at low prices as the market fell, and they were late to buy as the market recovered. In other cases, they attempted to time the market and missed.
“These biases are leading people to the ultimate trap in managing their portfolio – they’re buying high and selling low,” said Joe Correnti, senior vice president of brokerage product at Scottrade. “They’re moving in and out of the market, where sticking with their plan would have served them well.”
By identifying illusions, we hopefully are better able to counteract them.