5 Behavioral Finance Biases That Hurt Investment Decisions

behaviorial finance biases

Would you rather be paid $100 today, $120 a year from now or $144 in two years?

If you are like the majority of people, you will choose a crisp Benjamin Franklin $100 bill today rather than wait a year or longer to pocket more money.

That is the prediction from research conducted by the National Bureau of Economic Research, who discovered that 55% of people choose to pocket less money today than more money in the future.

The problem with this decision is it can be very costly for your retirement savings. Below we share the behavioral finance biases to blame for this investment decision and others that can be even more costly.

How Present Bias Lowers Your Wealth

The tendency to take the money now and run rather than wait patiently for more later is known as present bias and it can result in you saving less for retirement.

Another way to think about the trivia question above is that by choosing $120 in a year versus $100 today, you lock in a 20% return on the original principal.

If a bank savings account or dividend-paying stock offered a 20% return on investment, you might have jumped at the opportunity. But when offered the instant satisfaction of money now or more money later, the choice to wait is unattractive for most people.

Even though history shows that stock market returns average less than 10% per year, the offer to lock in a return of more than double the annual average is spurned because of human bias.

And there is worse to come! Another poorly understood human bias can further impact investment returns.

How Exponential Growth Bias Limits Returns

According to researchers, Gopi Shah Goda, Matthew Levy, Colleen Flaherty Manchester, Aaron Sojourner, and Joshua Tasoff, exponential-growth bias is to blame for fewer than 1 in 4 people choosing to wait two years for $144.

By patiently waiting for two years, it is possible to lock in a rate of return equivalent to 20% for the first year AND 20% for the second year. That translates to an extra $4 in earnings – because $20 was earned in the first year and $24 in the second year.

The reason most people choose the shorter time frame is because we humans are bad at predicting exponential growth over time. Instead, we assume that things grow linearly.

Perhaps one reason billionaire investors like Warren Buffett got so rich is they understand the power of compounding better than most. If we look a little deeper we can glimpse the effects of compounding investment returns.

In year 1, a 20% increase produced $20 in gains. In year 2, that same 20% increase generated $24 in gains. And by year 5, the same 20% return leads to $40 in gains! So, the same percentage increase each year continually produces ever more money.

The lesson is clear that patience pays investors ever more as time goes by.

How Hyperbolic Discounting Hurts Retirement Savings

Among the many behavioral finance biases affecting investment decision-making is the tendency to fall victim to hyperbolic discounting.

Here’s the first scenario. You can choose $50 now or $100 in six months. Which do you choose?

Keep that answer in mind and now answer the second question: Would you prefer $50 in 3 months or $100 in nine months?

Most people choose $50 as their answer to the first question but $100 as their answer to the second question, even though in both scenarios the extra $50 was earned by waiting for an extra 6 months.

The takeaway is that people avoid waiting more as the wait time nears the present time. Another way of saying that is people want to receive rewards sooner than later so the choice to delay a reward becomes less attractive and people discount them.

Hyperbolic discounting has applications beyond investing too. Anyone trying to lose weight will know the struggle of choosing dessert now versus better health later. In essence, they discount the health benefits later.

When it comes to retirement accounts, like an IRA or 401(k), economist David Laibson says hyperbolic discounting can limit the size of nest-eggs. People simultaneously take on high credit card debt while earning lower investment returns because they discount long-term rewards.

How Loss Aversion Can Increase Losses

Another behavior bias economics experts have identified that hurts investment performance is loss aversion.

For most people, it hurts more to lose $100 than it feels good to make $100. And that pain of loss can lead to poor investment decision-making.

An investor who bought say Facebook stock, Google stock, or Amazon stock, only to see the share price fall soon afterwards may be tempted to stick with their original bet. And perhaps they are right to do so if the companies are fundamentally strong.

But an investor who buys shares of a company that is fundamentally weak may also decide to hold on due to the human bias of loss aversion.

By selling shares and exiting for a loss, the investor has to admit the decision to invest was a poor one. By sticking with the original investment, they avoid crystallizing the loss even though further losses may mount.

Of all the behavioral finance biases that can impact investment returns, loss aversion may be among the most dangerous because some investors are so keen to avoid taking a loss that they will literally ride a stock price all the way to zero when a company is declared bankrupt.

Is Confirmation Bias Sabotaging Your Investments?

Have you ever had an inkling that a stock price would rise? Maybe you were an avid Twitter user and decided to buy Twitter stock, or perhaps you are a car buff and thought Autozone was a good buy?

Whatever the specific example, most investors have at some point been convinced the share price of a particular company would rise. And while that’s not a mistake by itself, the next step often is where problems arise.

Many investors then search for information to confirm their investment thesis. Instead of seeking information to challenge their ideas, they read articles that agree with their rosy outlook for the company and its share price.

That behavioral finance bias is known as confirmation bias and it affects investors of all kinds from the ordinary Joe or Jane Investor to managers of billion dollar funds.

The lesson is to scout for information that contradicts your thesis before placing an order on your favorite brokerage platform, like tastyworks or thinkorswim.

What behavioral finance biases have caused you to make poor investment decisions? Have you lost more than you should or made less than you could because of human biases?

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