There has been a lot of news about cryptocurrencies lately. Be it Bitcoin or Dogecoin or any of the others, you might be wondering – should I invest in cryptocurrencies? Or maybe you’re thinking – whew, I’m glad I didn’t put any money in cryptocurrencies! Before you invest in anything, consider if you are subject to behavioral-biased investing.
What are behavioral biases? According to the Chartered Financial Analyst (CFA) Institute, behavioral biases are either cognitive errors or emotional biases that may lead to sub-optimal decisions in investing. There are several different kinds of behavioral biases. Common behavior-biased investing in assets that you don’t own include:
Framing bias is the ability to present an opportunity in investing in a manner that makes it either more or less appealing.Â In investing, framing bias can cause you to think an investment is either good or bad. When there are fewer facts available to make a decision, the framing has a greater impact on the decision.
For example – bitcoin just made 1000% yesterday. You should invest in it. It could make another 1000% today. This completely overlooks the fact that bitcoin is not based on anything of actual value.
Regret is a powerful emotion that does not lend itself well to investing. Regret aversion bias is the bias where an investor seeks to avoid regret by failing to take a loss or capture a profit because they fear making a mistake.
I met a small business owner right after the 2008 market correction who was retiring. He was selling his $1 million company for a $150,000 gain. He had $250,000 in capital losses in his portfolio. Without getting into the taxation, I told him that he could actually offset all the gains from selling his business if he were to capture the losses and buy similar investments now, or the same investments 31 days later. He refused. He said that if he sold, he would be making a paper loss a reality. If he held on to his investments until they recovered, he wouldn’t have any losses. It pained him too much to think of capturing a loss, even though it would save him over $10,000 in capital gains tax.
Confirmation bias is seeking out information that only confirms what you already think.
If you want to buy a cryptocurrency, you may only read articles that suggest buying them and discount any articles that suggest you don’t buy cryptocurrencies.
A great example here is buying something on Amazon based on reviews. You might look at a product with a small sample size of reviews and decide that the reviews that favor the product are more important than the reviews criticizing the product. I know I’ve done that.
Choice overload is just as it sounds – being overwhelmed with all the choices and making no choice at all. This is easy to do with investing when you think about all the stocks or funds there are out there. With a little know-how, you can navigate this bias without worry.
Recency bias is when recent events influence investing more than their investment plan. For example – a recent stock market run is so good, investors think it’ll never end. On the flip side, when markets crash – it’s time to sell everything because it’ll take forever to recover. The best way to avoid recency bias is to have an investment plan that works in bull and bear markets, and stick to it.
Outcome bias happens when we invest based on the outcome of a previous event without considering the events leading up to that outcome.
A great example of outcome bias could be taken from the real estate market. A friend recently bought a house for $500,000. The market has dramatically increased in a short period of time and that same house is now up $100,000. I would be investing with an outcome bias if I bought a house now based on my friend’s good outcome. In addition, I might be investing at the top and see values fall.
Herd mentality investing is an investor’s tendency to invest in something because everyone else is doing it. They do not do their own independent analysis and instead are influenced by emotion and instinct.
Investing with a behavioral bias can lead to suboptimal outcomes. But it’s tough to know if you are falling victim to one of these biases. A better strategy is to have an investment plan that sets clear parameters as to when to buy and when to sell. This takes the emotion out of investing and can help you avoid behavioral biases.