5 Behavioral Biases That Can Impact Your Investing Decisions

The behavior of investors has long fascinated financial experts and academics studying behavioral finance concepts. This field examines how psychological factors and cognitive biases influence financial decisions, often leading to market fluctuations and potentially costly investment mistakes.

The definition of behavioral bias in finance encompasses how cognitive and emotional biases affect an investor's ability to process information and make rational economic decisions. Understanding these behavioral biases in investment decision-making is crucial for developing sound investment strategies and maintaining financial stability.¹

This article explores five common behavioral biases in investing that can inhibit investors' ability to make objective decisions and practical strategies to overcome them.

Overconfidence bias occurs when investors overestimate their own abilities, leading to potentially poor investment decisions. This common behavioral bias manifests across various domains. For example, the American Automobile Association (AAA) found that 78% of Americans consider themselves better-than-average drivers. Similarly, research from the Financial Industry Regulatory Authority (FINRA) revealed that 64% of investors believe they have a high level of investment knowledge. This cognitive bias can prompt investors to make high-risk investments based on an inflated assessment of their expertise.²

The abundance of online information can exacerbate this behavioral bias in finance, creating an illusion of comprehensive understanding. Investors often believe they can outperform market participants through their own research and active trading. However, actual market conditions tell a different story: In 2023, only a quarter of actively managed mutual funds had outperformed the market over the previous 10 years.²

To overcome this cognitive versus emotional bias, consider seeking input from financial advisors and carefully analyzing the past performance of your investment decisions. Conducting a "premortem" exercise—imagining potential outcomes of an investment strategy 10 or 15 years in the future—can help develop more rational decision-making processes. This approach helps you logically evaluate potential pitfalls and adjust your investment strategy accordingly.²

Herd mentality represents one of the most impactful behavioral biases in investing, emerging when investors make decisions based primarily on group behavior rather than independent analysis. This psychological factor often manifests through fear of missing out (FOMO), leading market participants to skip crucial steps like due diligence and fundamental analysis.

Studies of human behavior reveal a striking pattern: just 5% of informed investors can influence the decisions of the remaining 95%, highlighting how easily this cognitive bias can affect investment decisions. The bias frequently contributes to market bubbles and panic selling, as investors sell because others are selling without conducting their own research or considering their long-term investment objectives.³

For individual investors, combating this emotional bias requires developing a solid investment plan based on historical trends and personal risk appetite. Portfolio diversification helps minimize the impact of market fluctuations, while predetermined exit strategies can prevent reactive selling during market declines.

Professional financial advisors play a vital role in helping clients identify and overcome herd mentality. By assessing investments based on factual market conditions rather than emotional responses, advisors can guide clients toward more rational decisions that align with their long-term financial goals.³

Loss aversion bias research shows that investors experience the emotional impact of losing money more intensely than the satisfaction of achieving a similarly sized gain. This cognitive bias often leads investors to hold onto declining investments far longer than rational economic decisions dictate. Real estate investments clearly demonstrate how loss aversion bias affects decision-making, as investors frequently maintain losing investments well beyond the point where portfolio adjustments would be beneficial.⁴

To overcome this emotional investing bias, investors must develop predetermined exit strategies and assess investments based on current market value rather than initial trading price. Financial advisors often help clients identify this bias by encouraging them to:⁴

• Evaluate investments objectively based on factual market conditions
• Avoid emotional attachment to specific assets
• Implement systematic portfolio review processes
• Establish clear criteria for both buying and selling decisions
• Focus on overall financial stability rather than individual investment declines

This structured approach helps investors make rational decisions about their personal finances while minimizing the impact of loss aversion on their investment strategy.

The first information you receive about an investment is usually the most powerful. This common behavioral bias causes investors to place excessive weight on initial data points, often leading to faulty investment decisions. When you hear positive early reports about a stock's performance, for instance, you might continue basing decisions on this preliminary information while discounting more recent events that indicate changing market conditions.⁵

The impact of anchoring bias on investment strategy can be particularly problematic during periods of market fluctuations. Investors may cling to outdated reference points, such as a stock's past performance or previous market trends, rather than adjusting their analysis based on actual market conditions. This cognitive bias can significantly inhibit investors' ability to make rational economic decisions.⁵

To manage this behavioral bias in finance, investors and financial advisors should:⁵

• Regularly review portfolio performance against current market data
• Establish systematic approaches for assessing investments based on multiple indicators
• Maintain comprehensive tracking of market participants and trends
• Work to develop objective evaluation criteria
• Focus on factual market conditions rather than historical reference points

Among common behavioral biases, confirmation bias can lead investors to focus primarily on information that supports their existing beliefs while dismissing contradictory evidence. This behavioral bias is particularly challenging because it creates a comfortable feedback loop, reducing investors' perceived need to question their mental accounting processes. For example, if you've determined that certain mutual funds align with your investment strategy, you might automatically seek out positive reports about these funds while minimizing attention to data suggesting poor investment decisions.⁶

Human nature makes common biases like this difficult to overcome. The impact of confirmation bias extends beyond individual investments to affect overall personal finances. Institutional investors and individual traders alike may miss opportunities to enhance their financial well-being when confirmation bias leads investors to ignore objective market data. Additionally, this bias can become particularly problematic during periods of financial crisis, as investors seek information that confirms their existing positions rather than adapting to changing market conditions.⁶

To help clients develop strategies for overcoming this bias, financial professionals recommend:⁶

• Actively seeking contrary viewpoints about desired investments
• Challenging assumptions about historical trends
• Conducting thorough research that includes opposing perspectives
• Asking open-ended questions rather than seeking simple validation
• Regularly reviewing investment performance against objective benchmarks

Understanding how to identify and manage behavioral biases is valuable for both personal investing and corporate financial management. While working with financial advisors provides a helpful perspective, developing your own expertise in behavioral finance can improve both individual investment choices and organizational decision-making.

Businesses across industries need professionals who understand the intersection of human behavior and financial analytics. This knowledge proves especially valuable when guiding teams through complex financial decisions or creating effective asset allocation strategies.

Understanding these common investment biases helps you:

• Apply objective analysis to investment choices
• Guide strategic planning with clear data
• Make sound decisions during market fluctuations
• Build sustainable financial strategies
• Evaluate opportunities systematically

William & Mary's Online Master of Science in Finance (MSF) equips you with advanced analytical skills and deep financial knowledge to excel in today's global business environment. The comprehensive curriculum combines rigorous quantitative training with practical applications, preparing you to:

• Lead data-driven financial strategies
• Navigate complex market conditions
• Make informed investment decisions
• Guide corporate financial planning

You can complete your master's degree and a specialized finance certificate in as few as 16 months while learning from industry-leading experts. The Online MSF program helps you develop the expertise needed to identify opportunities, analyze risks and create lasting value for your organization. Learn more about program admissions and talk with an admissions outreach advisor to move forward on your path to financial expertise.