What is behavioral finance?
Behavioral finance is a field of study within economics that explores how human psychology can influence our spending, saving, and investing decisions—often for the worse, rather than for the better. Too often, our human tendencies lead us to make ill-advised financial decisions. While these mistakes eventually become apparent in hindsight, they may be hard to avoid at the time of decision-making, when fear, greed, or other emotions can easily overwhelm rationality.
When it comes to investing, our emotions naturally make it difficult to make smart decisions such as buying low and selling high. In general, that’s why many investors sell during market declines—thereby locking in losses—and return only after stocks have recovered. Research suggests that these behavioral biases are a key reason why the average investor underperforms the market.
Trying to time the market has often resulted in underperforming the market
Average annual returns, S&P 500 Index vs. equity mutual fund investors, 1999–2021
Source: DALBAR’s Annual Quantitative Analysis of Investor Behavior, DALBAR, Inc., 2022. Investor returns are calculated using data supplied by the Investment Company Institute that represents the change in total mutual fund assets after excluding sales, redemptions, and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses, and any other costs. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Six common investing biases and how to remedy them
By taking a closer look at some of the basics of behavioral finance, investors can learn to let logic, rather than emotion, drive their investment decisions.
1. Loss aversion: Loss aversion is the human tendency to strongly prefer avoiding losses over acquiring gains. This cognitive bias stems from the fact that the psychological impact of a loss can be far more powerful than the impact of a gain. This overwhelming fear can lead to poor investment choices such as holding onto an investment for too long or too little time.
How to remedy loss aversion bias?
Don’t just be prepared for market volatility—expect it. This mindset allows investors to plan ahead for trouble, so they’re not making decisions under duress. Once you create a disciplined, sensible long-term plan, stick to it. Try to resist the temptation to question your previous choices, as your loss aversion bias could kick in during periods of market volatility and potentially skew your decision-making. One way to address loss aversion bias is to work with a financial professional, who can help a client develop an investment plan and take a bigger picture view of the markets during times of market stress. Another approach is to invest through dollar cost averaging, which involves continuously investing regardless of market movements. Dollar cost averaging¹ can be done through paycheck deductions to a workplace savings plan such as a 401(k) account. By regularly investing a set amount, you end up buying more of an investment when prices are low (as in the case of a market decline that reduces stock prices, for example) and less when prices are high. By investing periodically, you may find yourself worrying less about the market’s movements from one quarter to the next, even if they may feel dramatic at the time.
The value of staying invested
Staying fully invested helps to ensure that an investor participates in the market’s best days
Source: Bloomberg, as of 12/31/21. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. This chart is for illustrative purposes only and is a hypothetical example that does not reflect the performance of any John Hancock fund. Past performance does not guarantee future results.
2. Anchoring: The anchoring effect is a cognitive bias in which a particular reference point or “anchor” influences an individual’s decisions. In investing, this bias rests on the common human tendency to rely too heavily—or anchor—on one trait or piece of information, most often the first piece of information an investor is given about a topic when making decisions. This bias can skew judgment and prevent an investor from updating plans at appropriate times.
How to remedy anchoring bias?
Keep an open mind and seek out information that will provide a long-term perspective and help you change your anchor. Also, measuring success based on progress toward goals is a good way to maintain objectivity.
3. Status quo bias: This tendency is a cognitive bias reflecting the reality that humans are creatures of routine. This bias suggests that people tend not to change an established behavior unless the incentive to change is compelling. As a result, investors presented with lots of complex choices are most likely to choose the option that extends their current arrangements. This is why an investor’s initial portfolio allocation is tremendously important, as it has an enduring impact.
How to remedy status quo bias?
Make an investment plan and stick to it. Relying on the guidance of a financial professional can help you make a well-informed investment plan to begin with. It’s also important to revisit the plan periodically to ensure that it still aligns with your long-term goals.
4. Procrastination: This is an emotional bias reflecting the fact that investors have a positive bias toward the present (e.g., wanting to relax today and invest next week). There’s also anxiety when starting a complex task, such as revisiting or changing portfolio allocations, so investors tend to leave things as is or put it off for later.
How to remedy procrastination bias?
Make a schedule and revisit your investment plan at regular intervals. Engage with a financial professional in setting a schedule and hold yourself accountable; set reminders to help stay on track. Learning what motivates you to invest—maybe more financial security after retirement or saving up for a bigger house—will also help you combat procrastination. Finally, create an incentive by rewarding yourself for making progress toward your goals.
5. Hindsight bias: Why do people typically begin to practice healthy eating and exercise regularly only after having a health scare, rather than embracing those healthy habits beforehand to potentially prevent the health problem from happening in the first place? Blame hindsight bias, which is an emotional bias causing investors to take action after it’s too late. Essentially, it’s locking the barn door after the horse has run away; however, it’s important to remember that past performance does not guarantee future results.
How to remedy hindsight bias?
Remember that you probably did the best you could with the information you had at the time you made an investment decision. Secondly, take a long-term perspective when reevaluating your investment plan. One strategy to overcome hindsight bias could be to write a letter to yourself about the rationale for your long-term plan, seal it, and write on it, “Open in case of an emergency.” If you get concerned about recent changes in the market, read the letter to help keep things in perspective.
6. Availability: This is a cognitive bias rooted in the tendency to make decisions based on the information that’s the most readily available when you’re making the decision. This results in overestimating the probability of an event because it’s associated with a previous memory. Also, it’s important to note that this bias can be reinforced by the prevalence of media coverage on daily market movements and volatility. While you don’t necessarily need to ignore these fluctuations, it’s helpful to keep this temporary noise in perspective and try to stay on track in pursuing your long-term goals.
How to remedy availability bias?
The first rule to combat availability bias in investing is to not believe everything you hear. Bad news also sells newspapers and generates clicks. It’s worth bearing in mind that sometimes even experts—not just your neighbors and friends—can be wrong about market-moving news and predictions. Instead of questioning and changing your investment plan whenever the market has a blip, it’s important to remember that systematic investing can work in up and down markets.
Overcome your natural biases and invest logically
One reason that many investors fail to fully realize the market’s investment potential is that the physiology of our brains might be working against our best interests. Investors can help minimize the damaging effects that these biases have on long-term goals by staying alert to these tendencies and following a few simple principles and best practices. It can help to have a plan and a financial professional who you trust to help you implement your plan.
Consider consulting with a financial professional and reviewing our resources
Your financial professional can help you build a plan that considers your goals, risk tolerance, and time horizon. In addition, we offer a suite of resources to help financial professionals and their clients overcome biases and adhere to time-tested principles. Finally, our Decision Economics series describes a behaviorally informed framework that financial professionals can leverage for making investment decisions and assisting clients.
1 Dollar cost averaging does not ensure a profit and does not protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.
The views expressed in this material are the views of the authors and are subject to change without notice at any time based on market and other factors. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index, and is not indicative of any John Hancock fund. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed. Past performance does not guarantee future results.