From loss aversion to social proof: The four unconscious biases tanking your investments

Originally shared by Smart Company July 11th

Subconscious behavioural shortcuts are wreaking havoc on your share portfolio. Decades of behavioural science research inform us that humans aren’t rational decision-makers. Instead, it’s hard-wired, often irrational biases, known as heuristics, calling the shots. They occur because our brains are lazy and our lives are busy, allowing us to make choices quickly without investing excessive time and effort into researching and evaluating every decision.
But, unfortunately, the price we pay is an endless list of imperfect, irrational decisions based on emotion, biases, and the context in which they’re made. Deeply ingrained in our evolutionary history, these biases are especially pertinent to financial decisions, as money and stock markets are recent phenomena. For context, the earliest Homo sapiens appeared around 300,000 years ago, themselves just the latest link in an evolutionary chain stretching back millions of years before that. The brains that we’ve inherited and the wiring within them have origins that predate dinosaurs. 

By contrast, to find the origins of modern-day money, we need only glance back to Mesopotamia (modern-day Iraq) some 5,000 years ago. The first stock exchange? Not even 500 years in our evolutionary rear-view mirror. 

By simply understanding the deep psychological machinations at play, investors can make more informed decisions, lower risk, avoid costly mistakes, and, fingers crossed, improve investment returns.

Here’s what you need to know.

Loss aversion 

According to Prospect Theory which won the Noble Prize for Economic Sciences in 2002, “Losses loom larger than gains” in the human mind. The theory discovered by behavioural science forefathers Daniel Kahneman and Amos Tversky found we endure twice the psychological distress when faced with losses, in contrast to the psychological satisfaction derived from gains. Put simply, if we lose $10 in the street, we need to find $20 in our pants pocket to come out emotionally even. 

This overwhelming fear of loss can cause us to behave irrationally and make bad investment decisions, such as holding onto an underperforming stock for too long, to avoid having to make the loss ‘real’.  You may recognise this behaviour from endlessly ploughing cold hard cash into a lemon of a car in the hope of someday making your money back when you sell it.

By holding on and remaining anchored to past investment decisions, we don’t have to deal with the emotional burden of regret. However, with that comes an opportunity cost, such as squandering profit-making opportunities elsewhere.  

Being aware of this entrenched bias towards loss should be enough to, at least, make you question whether you’re holding ‘down stocks’ for a sound, rational reason or just subconsciously trying to avoid the reality of realising the losses and the psychological pain that goes with it.

Confirmation bias

Our brains love to prove ourselves right. Confirmation bias refers to the tendency to seek or emphasise information confirming a pre-existing belief system or hypothesis. If you take a position on a company or a type of stock, your brain selectively seeks information supporting that choice. At the same time, it ignores and disregards contradictory information that goes against it. 

For example, if you decide lithium is the future and invest heavily in lithium shares, your brain will subconsciously seek out every news article, blog post or tea room conversation that confirms this to be true. While discrediting anything that says lithium’s overhyped and hydrogen is where it’s at. 

Hence, there is a need to constantly challenge our assumptions by consistently asking ourselves why we might be wrong rather than why we might be right.

Social proof

The term social proof was coined by the leading scientist in the field of influence, professor emeritus of psychology and marketing Robert Cialdini, in his landmark book Influence: The Psychology of Persuasion. He defines social proof as “People doing what they observe other people doing”. 

Social proof touches the deep, psychological wiring within us that says being with others is safer. As a result, it can be an incredibly effective tool for unfamiliar, infrequent or high-risk purchases, like investing.

Investors often emulate the actions of others. We buy what everyone’s buying. We sell what everyone’s selling, creating speculative bubbles and fueling market volatility. Because of it, companies’ valuations sometimes swing double-digit percentages in a single day without any underlying rationale.  

Many investment decisions are made with limited knowledge. So naturally, we will look at what your broker, best mate, Uber driver, market tipsters, financial media, and family members do for a steer.

However, beware of herd behaviour. If everybody is talking about it, you’ve probably already missed that gravy train, and you are at risk of buying at a high point. The answer? I’ll defer to Warren Buffett: Buy when others are fearful and sell when they’re confident. If you can’t see a good reason why a stock is moving up or down, there’s a good chance there isn’t one.

Anchoring bias 

First conceived by Tversky and Kahneman, anchoring bias proved that presenting an initial figure caused people to use that number to estimate unknown quantities. As a result, any subsequent information received becomes weighted against the first figure. 

We rely on initial information or reference points when making decisions, which can subconsciously influence later perceptions, subsequent decisions, and further judgement calls. When investing, it feels perfectly pragmatic to base decisions on a stock’s recent share price relative to its trading history or what you originally paid for a stock. 

However, anchoring can lead to irrational decision-making, as investors may hold onto a stock for longer than warranted or fail to adjust their valuation based on changing market conditions. Instead of being open to new information, there’s a mindset that is always subconsciously anchored to the original purchase price. Instead, focus on researching the stock’s future prospects, as that is where you’ll predict where the stock is heading. 

Dan Monheit is a behavioural science expert and the CEO of Hardhat.