What Are Investor Biases and How Can They Impact Portfolio Returns?

A psychological bias in investing manifests when investors make decisions based on experience, personal beliefs, or emotions rather than on objective investment criteria. Biases can influence investors to make bad decisions, which may affect their ability to achieve their long-term investment goals.

Regret aversion occurs when a decision is made to avoid regretting an alternative decision later on. For example, an investor may purchase popular investments even if they don’t align with the investor’s risk tolerance or long-term goals.

A prime example of this is cryptocurrency investments, which may be volatile and not an ideal fit for every portfolio. Despite the risks and downside potential, certain investors may have invested due to fear of missing out on potential sky-high returns. As a result, some of these investors may have experienced uncomfortable levels of loss and sold at record lows due to their inability to withstand the risk involved.

Regret aversion can be avoided by having a long-term plan and staying committed. An investor can more easily prevent emotional buying and selling by maintaining a well-defined investment plan that aligns with financial needs and goals.

See more: 10 Common Trading Mistakes to Watch For

An investor’s familiarity bias is the tendency to gravitate towards investments they’re already familiar with, likely due to discomfort with the unknown.

This may include investing in stocks or bonds that the investor already owns. Familiarity bias can lead to a holding-concentrated portfolio in a smaller set of assets you’re familiar with, limiting diversification and forgoing investment opportunities.

Additionally, investors who only invest in domestic securities may miss out on the compelling opportunities and diversification found in global securities.

To overcome familiarity bias, investors should maintain a diversified portfolio. This means diversifying investments across asset classes, sectors, and geographies, which may enhance risk-adjusted returns by spreading out risk.

Another solution is to consult a financial advisor. An objective viewpoint can help an investor make unbiased investment decisions.

The disposition effect refers to investors’ tendency to prematurely sell assets that have generated financial gains while holding onto assets that have been losing money for too long. Furthermore, investors generally feel a financial loss more strongly than a gain of the same magnitude.

Market downturns are a normal part of a regular business cycle. However, investors who let emotions creep into their decision-making might make investment decisions that harm their long-term goals.

Investors can avoid disposition bias by sticking to the long-term plan and avoiding watching day-to-day fluctuations too closely. A well-defined investment plan can help investors focus on the long term and may even enable them to purchase securities during a downturn while trading at a discount relative to its intrinsic value.

Anchoring bias causes investors to rely too heavily on information received early in decision-making. Investors may use this early information as a reference point to base future decisions, even if the information is irrelevant or arbitrary, which may lead to trouble.

Anchoring bias may lead investors to hold a security for too long as they continue to refer back to the purchase price or another metric that is no longer fundamentally sound. Conversely, it might look like missing out on investment opportunities based on outdated information and analysis.

The best way to avoid anchoring bias may be to consult a financial advisor or invest in an ETF or mutual fund managed by a team of experienced investment professionals.
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