The stock market is not as rational as it seems. It sometimes behaves irrationally. Indeed, individual investors, especially inexperienced ones, trade based on emotions or sentiments, which can lead to less-than-optimal portfolio performance.
More often than not, this group of market participants are unaware of the behavioral biases that drive their investment decisions. It is commonly observed in the stock market that individual investors exhibit the following irrational behaviors: disposition effect, confirmation bias and familiarity bias.
Disposition effect: This bias refers to the tendency that investors sell winning stocks too soon in order to realize profit while keeping losing stocks for an extended period of time as they expect a recovery just around the corner. This irrational behavior is caused by a blend of two opposite emotions (fear vs. hope). Specifically, people tend to fear that good things won’t last long, yet hope that bad things will end soon. In addition, getting rid of a loss position is also equivalent to admitting that their previous purchase decision was wrong, which is sometimes hard for investors to assent . Similarly, investors are tempted to realize small gains in winning stocks since such a decision means that they were right with their bets.
Confirmation bias: A confirmation bias occurs when investors search for, interpret, infer, favor, and accept information that supports their prior beliefs about an investment while, at the same time, they ignore or refute contrary information. Psychologically, people tend to experience confirmation biases because they subconsciously want to protect their self-esteem, process information efficiently with minimum costs and efforts, as well as avoid holding multiple conflicting beliefs that can cause excessive mental stress.
Familiarity bias: When investors are susceptible to put money in stocks they have a history with or know well, it is likely that they are affected by the familiarity bias. The fear of incurring losses makes people trapped in their comfort zones. By sticking with familiar stocks, investors think they would face less risk. However, the truth is they unknowingly increase the risk associated with their stock portfolios due to insufficient diversification .
So, how do we overcome these irrational behaviors and make better investment decisions? The first and most important step is to realize and acknowledge the existence of such behavioral biases. There is no reason to feel guilty or embarrassed if one day we find out that the trading decisions we have made so far are not as rational and optimal as we expected. That is just how human beings behave.
Once the acknowledgment has been made, it will be much easier to digest the specific tips on how to deal with each behavioral bias separately and make less biased investment decisions. With the disposition effect, it is useful to know that good-performing stocks are hard to identify and the stock price momentum can last for a while , which helps us resist the temptation to sell winning stocks too soon or to keep losing stocks for too long.
Concerning the confirmation bias, it is important for investors to learn to accept different perspectives and control the fear of listening to dissenting opinions from others. With the familiarity bias, perhaps the most effective remedy is to keep reminding ourselves that familiarity does not always provide true safety and security for our stock portfolios. Sometimes, venturing into uncharted water and purchasing unfamiliar stocks will help instead.