Researchers have identified more than 100 behavioral biases that can undercut effective investment decision-making, according to Michael Pompian, founder and partner at Sunpointe Investments and author of “Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases.” In a course taught for the CFA Institute, Pompian identifies seven biases as the most common emotional influences on investment decisions.
Pompian says “loss aversion,” for one, crops up when an investor is reluctant to sell a poorly performing investment and redeploy assets into a more promising opportunity.
“You’re waiting in a bad investment because you can’t face the fact that you’re having to take the loss,” he said. “The more rational approach is to take your loss, record the tax loss and move on to something that has better prospects.”
Another emotion-driven hangup is called “anchoring.” This can occur when an investor uses the price paid for a stock, exchange-traded fund or mutual fund as a reference point for decisions, Pompian said.
A more rational investor would use an unemotional measure, such as price-earnings ratio. “The proper reference point is the proper valuation for the security, not what you paid for it,” he said.
In advancing markets, overconfidence can become a problem emotion. “That’s when the market is doing so well you’re not paying attention to the underlying risk,” Pompian said. “It’s essentially unwarranted faith in your own abilities.”