In this article, I'll explore 14 common behavioural biases, explain their impact, and offer actionable strategies to mitigate them. While I explore the biases in turn, they don't occur in isolation. When making investment decisions, we can be hindered by several biases combining to lead us astray.
14 Behavioural biases to avoid
Behavioural biases can be split broadly into two categories, cognitive biases and emotional biases. Cognitive biases are errors in thinking or information processing, while emotional biases stem from feelings and emotional responses that can lead to irrational decisions.
Common Cognitive Biases in Investing:
1 - Loss Aversion
Investors tend to feel the pain of losses more strongly than the pleasure of equivalent gains. This fear of loss can lead to impulsive decisions, especially when they see their investments decline in value.
Example: Loss aversion can cause investors to hold onto a losing stock or fund for longer than they should because they are afraid of realising the loss, even if selling the stock and reinvesting the proceeds in a more promising opportunity would be the rational choice.
Ironically, we are seeing a real-world example play out right now in US tech stocks. Following the release of the Chinese AI model DeepSeek, Nvidia's share price plummeted 18% in a single day due to concerns that a new, lower-cost AI model could disrupt the US's dominance in the AI sector, potentially reducing the demand for and profitability of Nvidia's expensive chips. Loss aversion is driving much of this behaviour, as no one has yet been able to verify the claims made by DeepSeek's creators or quantify its future impact on the future of AI. Perhaps DeepSeek's advancements could be positive for AI stocks, driving down the cost of AI and increasing consumer adoption, which would be good for companies exploiting the technology. Who knows? But Nvidia investors are focusing on the 18% loss right now and reacting to the news rather than the 200% gain they've made since ChatGPT made its debut in November 2022.
Strategy to mitigate impact: Setting stop-loss orders helps limit potential losses and prevents emotional decision-making during market downturns. It's one of the reasons that 80-20 Investor contains stop loss alerts. Also, maintain a long-term perspective by focusing on long-term goals rather than short-term market fluctuations. One of the key takeaways from my investment research article "What's the best strategy when investing cash, all at once or dripping in?" was "if you are worried markets are likely to fall then the best way to mitigate the impact is actually to increase your investment timeframe and review your portfolio more regularly".
2 - Confirmation Bias
This is where you seek out information that confirms your existing beliefs while ignoring contradictory evidence.
Example: Imagine an investor believes a particular tech company is the "next big thing." They might eagerly read articles about the company's innovative products and growing market share, while conveniently ignoring reports about its mounting losses or competitive threats. Any concerns about the company's valuation or management team might be dismissed as negativity or short-seller manipulation. Furthermore, they might primarily follow analysts who are optimistic about the company's prospects while ignoring those who express caution. This confirmation bias can lead to over-investment in the company, blinding them to warning signs and potentially causing significant losses if the company fails to live up to its hype.
Confirmation bias even means that we tend to more easily recall things that reaffirm our belief over those things that don't. If you want to see how we all easily fall victim to confirmation bias, watch this video on YouTube - 'Can you solve this?'
Confirmation bias is also prevalent in the mainstream media, where the same viewpoints are often disseminated by experts, whether on the likely path of future interest rates or the future of AI stocks.
Strategy to mitigate impact: Simply trying to become aware that you are looking to reaffirm what you already believe is enough to make you stop and think. Also, try and spot the confirmation bias in investment experts' quotes and soundbites. Make sure you actively seek out diverse perspectives and consider the opposite scenario in any instance. Challenge your assumptions, acknowledge the limitations of your knowledge, and focus on continuous learning.
3 - Anchoring Bias
This is the tendency to over-rely on the first piece of information received (the "anchor"), even if it's irrelevant. This initial anchor can significantly influence subsequent thoughts and decisions, even when presented with conflicting or more accurate information.
Example: In terms of investing, it can mean anchoring on the price at which you bought a fund or share. Or it could be the previous valuation of a fund or portfolio the last time you checked. That number then takes on increased importance and will often influence investors' decisions on whether to sell or keep an investment. It is probably one of the biggest biases that people new to 80-20 Investor struggle with. Long-term subscribers will know that I never reference the price at which I buy a fund. I also don't let the profit or loss on a holding within my portfolio dictate whether I sell it or not. I am just as happy selling a fund for a loss as I am a profit if I believe there are better opportunities elsewhere. The aim is to limit the size of any losses and maximize the profits I make when I get it right. The way I do this is by following a process; otherwise, I, like everyone else, would inevitably allow my emotions to creep in.
Strategy to mitigate impact: Sticking to an investment process helps reduce the impact of anchoring. If you read my monthly portfolio updates, you will see that I apply the same process objectively each month with no reference to the original purchase price or profit/loss of a holding.
4 - Availability Heuristic
This is when you overestimate the likelihood of events that are easily recalled.
Example: Scarred by the 2008 financial crisis, an investor avoids equities, keeping most of their money in cash and missing out on long-term growth potential.
Strategy to mitigate impact: Understand market cycles, diversify, and educate yourself on the historical performance of assets over time.
5 - Mental Accounting
This is when you treat money differently depending on its source or intended use.
Example: Imagine you have two shares: Share A, with a £500 profit, and Share B, with a £200 loss. Mental accounting might tempt you to treat the Share A profit as "house money" or "free money", leading you to take more risks with it, like investing in a higher-risk investment. You might even rationalise that losing it wouldn't be a big deal since you're already "up." However, this is irrational. That £500 is no different from any other money you have.
Strategy to mitigate impact: View finances holistically, allocate money according to overall goals. So in the above example, instead of mentally earmarking the £500 profit, consider your overall portfolio and goals. It might be wiser to offset the loss in Share B, invest in a less risky asset, or use it towards a financial goal. If you look at my portfolio reviews, I don't reference the individual profit or loss of any holding and instead focus on the portfolio's overall performance.
6 - Hindsight Bias
This is when you believe past events were predictable.
Example: An investor claims they "knew all along" Brexit would happen and make future investment choices based on their perceived ability to predict geopolitical events.
Another example could be someone who, in early 2020, as the COVID-19 pandemic spread and global markets plummeted, decided to make a small investment into stocks against the prevailing market fear. Following unprecedented monetary and fiscal stimulus across the globe, stock markets rebounded aggressively, which would have quickly seen the investor's small equity investment rally significantly.
Now hindsight bias would lead the investor to state that it was obvious that stocks would experience a V-shaped recovery and exceed pre-pandemic levels within a year. They would bore anyone who would care to listen about their genius and how they made a killing. This inevitably leads to overconfidence (another bias covered later) impairing their future investment decisions.
The reality was that back in the depth of the pandemic equity slump, no one knew what was going to happen. Countries were still in lockdown and entire economies had ground to a halt, while the potential dangers of COVID-19 were still not fully understood. No one could foresee the scale of stimulus that was launched by governments and central banks, nor the speed at which a vaccine was developed. Claiming that it was foreseeable is hindsight bias.
Strategy to mitigate impact: As you know, for the last decade, I have published an investment newsletter each week and published my portfolio reviews every month. That is something in the region of 500 newsletters and 50+ portfolio reviews.
As such, there is a complete record of every thought I have had and the investment decisions I have made, along with my rationale. This prevents any hindsight bias from entering my decisions because I can simply go back and see the information I had when I made any predictions or decisions. Now obviously, I don't suggest that you produce such a volume of work but if you keep a record of any predictions or investment decisions you make along with their rationale it will help you recognise the unpredictability of events and help avoid hindsight bias.
7 - Framing Bias
This is where investors make different choices based on how information is presented.
Example: An investor is more likely to choose an investment with a 90% chance of success than one with a 10% chance of failure, even though both have the same outcome. The only difference is how they are framed.
Framing is also a marketing technique used when naming funds. Some investors can be swayed by phrases such as "Rising Stars" being included in fund names. In reality, the name should offer no comfort that the fund manager can pick stocks that will rise in value.
Strategy to mitigate impact: Always reframe options and focus on underlying facts and data. Also, avoid being swayed by presentation.
8 - Home Bias
This is where you favour investments in your own country.
Example: This is prevalent in every country. In the UK, investors often primarily invest in UK companies, potentially missing out on gains in faster-growing economies.
Strategy to mitigate impact: Consider global diversification across all asset classes. Also, use an investment process that doesn't discriminate against geographies and one that doesn't allow any particular geography (home or otherwise) to become too dominant.
9 - Recency Bias
This is where you give more weight to recent events or performance.
Example: After the bull run in tech stocks, an investor pours all their savings into tech funds, neglecting other asset classes, risking losses if the sector corrects.
Another example could be that you are about to add a fund to your portfolio but the stock or fund has slumped in recent days. You instead decide to choose another fund which hasn't been as consistent or a profitable performer over a longer timeframe because the recent slump is in your mind.
Strategy to mitigate impact: Look at performance data over longer time periods and don't just focus on short-term fluctuations.
Common Behavioural Biases in Investing:
10 - Herding Bias
This is essentially when you go with the crowd, even if it goes against your judgment and is most closely linked with FOMO (the fear of missing out)
Example: Driven by FOMO, a UK investor jumps on the meme stock and cryptocurrency bandwagon without understanding the risks because everyone else is doing it.
Interestingly it raises the question of whether momentum investing is built upon the concept of herding bias. While herding bias and momentum investing might seem similar at first glance, they are fundamentally different approaches. Herding bias is primarily driven by social factors, like the fear of missing out or the assumption that the crowd knows something you don't. This can lead to irrational behaviour, such as chasing bubbles or participating in panic selling, driven more by emotions than by fundamentals. Essentially, herding bias focuses on what others are doing, regardless of the underlying investment's merits or data.
In contrast, momentum investing is driven by data and trends. It uses objective data and analysis to identify assets with strong upward price trends, based on the rationale that these trends tend to persist for some time. Momentum investing can be implemented with a systematic, rules-based approach that incorporates risk management techniques, which is exactly what 80-20 Investor does. The emphasis is on the asset's price performance and underlying trends, not on what other investors are doing.
Strategy to mitigate impact: Again, stick to an investment strategy, stick to your plan and understand the investments you hold. Ask yourself the question, am I only considering this investment because of what other people are saying or doing?
11 - Overconfidence Bias
Overestimating your abilities and knowledge.
Example: An investor with some success trading individual stocks becomes overconfident, makes riskier bets using leverage and ignores warning signs, leading to significant losses.
Warren Buffet, one of the most successful investors of all time, has emphasized the importance of knowing your "circle of competence". Your circle of competence refers to the areas where you have genuine knowledge and expertise. Warren Buffett said, "Know your circle of competence, and stick within it. The size of that circle is not very important; knowing its boundaries, however, is vital."
In other words, invest in what you know, and avoid what you don't. This helps you make better investment decisions because you can accurately judge the opportunities and risks. This is principally why I don't invest in individual stocks or crypto. It's not my area of expertise and why 80-20 Investor focuses instead on building portfolios using unit trusts, investment trusts and ETFs. The success of my portfolio over the last decade is evidence of the benefits of sticking to your circle of competence.
Strategy to mitigate impact: Acknowledge limitations and be humble about your investment prowess.
12 - Status Quo Bias
This is where an investor prefers to stick with the current situation.
Example: An investor invests in the default fund within their company pension for years, even though their circumstances and goals have changed, leading to missed opportunities and a portfolio that does not align with their goals or attitude to risk.
Strategy to mitigate impact: Regularly review and rebalance your portfolio, consider new investment options, and seek professional advice if you are unsure.
13 - Endowment Bias
This is when you value something more simply because you own it.
Example: An investor holds onto inherited shares in a struggling UK manufacturing company due to sentimental value, despite the financial benefits of selling and reinvesting.
Now this may sound similar to status quo bias but they are different. While both make us resistant to change, they stem from different places. Endowment bias makes us overvalue what we own due to emotional attachment and fear of loss, like refusing to sell an old car for a reasonable price. Status quo bias, on the other hand, is a general preference for things to stay the same, driven by inertia and a desire to avoid making decisions, such as sticking with a default investment option even if it's not suitable for you.
Strategy to mitigate impact: Evaluate investments objectively, consider opportunity cost, and separate emotions from financial decisions.
14 - Authority Bias
This is the tendency to overvalue the opinions and recommendations of authority figures, such as experts, celebrities or successful investors. We often defer to authority figures, even when their expertise might not be relevant to the specific situation.
Example: An investor sees a famous fund manager on television recommending a particular stock. Impressed by the manager's reputation and track record, the investor buys the stock without conducting their own research. This can lead to poor investment decisions if the stock is not suitable for the investor's circumstances or if the fund manager's recommendation is based on flawed information.
It is an important bias and why I built 80-20 Investor as a tool that was not dictatorial. It can be used by investors how they wish and ultimately means that there is not one outcome from using the information provided. This was incredibly important to me as I know how powerful authority bias is. My aim has always been to teach people how to invest and manage their own money. Not to tell them how to do it. Something which I like to think I have achieved.
Strategy to mitigate impact: While it's valuable to learn from experts, it's crucial to develop your critical thinking skills. Question assumptions, seek out diverse perspectives and conduct your own due diligence before making any investment decisions. Remember that even the most successful investors can make mistakes and their recommendations might not be aligned with your individual goals and risk tolerance.
Summary
Ultimately, it's not about being a perfectly rational investor immune to biases. We're all human, and these biases are deeply ingrained in our psychology. What matters is recognising when these biases might be influencing our decisions and taking steps to mitigate their impact. By understanding how our minds work, developing a sound investment process and seeking objective advice when needed, we can improve our decision-making and increase our chances of investment success.
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