Behavioral finance: How to avoid the 13 biggest investment mistakes

Many, including the most harmful investment mistakes, are based on behavioral patterns that we have trained ourselves to adopt over thousands of years for the survival of our species. The problem is that these irrational behaviors are still deeply rooted in us today. Mentally, we have largely remained hunter-gatherers. Actions that were vital to our survival as cavemen back then are now detrimental to our investments. Incidentally, professionals and private investors alike are affected by these psychological pitfalls.

In this article, we want to sensitize you to the biggest errors in thinking in connection with your investments and show you effective countermeasures. In doing so, we draw on scientific literature in the field of the more recent research area of “behavioral finance”.

Introduction

What do “behavioral finance” and “bias” mean?

Before we really delve into this fascinating topic and look at what we consider to be the 13 biggest psychological pitfalls when investing, we would like to clarify two key terms below:

Behavioral Finance

Behavioral finance is a new field of research in finance that analyzes the psychology of investing. This short definition comes from the University of Zurich or from the description of its “Behavioral Finance” course. In an ideal financial world, completely rational investors (“homo oeconomicus”) are able to classify all information on the market without error and draw purely logical conclusions from it. In reality, however, investors act irrationally, assess certain information as more or less important than it is, and thus make the wrong investment decisions. Behavioral financial market theory, as “behavioral finance” is called in German, explains why this is the case – and why repetition of these decisions leads to supposedly illogical developments on the markets.

Bias

Biases are distortions. In this article, we focus on cognitive biases that are systematic and erroneous in nature, scientifically confirmed and related to the topic of money. Biases according to this definition lead us to irrational behavior in our finances.

And another important note: If you think that bias only affects fools, then you are unfortunately mistaken. Bias affects all levels of education, albeit to varying degrees depending on the bias. As we will see later on, sometimes even highly educated people are more affected by bias than more simple-minded people.

In this article, we use errors of reasoning or psychological pitfalls as synonyms for bias.

How are biases determined?

To determine systematic erroneous cognitive distortions, rational comparison standards must first be developed using testable rules. Systematic, i.e. not individual and random, deviations from these standards are then considered irrational or incorrect.

Why did you choose these 13 errors of reasoning?

We took a systematic approach and went through the following four steps to select the 13 biggest errors in thinking.

1. Reading specialist literature by various authors (see this chapter)
2. Making a pre-selection (population) of around 100 thinking errors (largely based on the two works by Dobelli)
3. Analysis of pre-selection and identification of the most important thinking errors related to the topic of money
4. Determination of a ranking of the 13 previously identified errors of reasoning (ranking)

Incidentally, even though the unlucky number “13” naturally fits well for a ranking of the biggest investment mistakes, we didn’t have a specific number in mind at the start of our analysis. After our research, we were simply left with 13 misconceptions that we considered to be particularly relevant in connection with the topic of money.

But enough of the introductory words and enjoy reading!

The 13 biggest investment mistakes

Overview

We have selected the following errors of reasoning that are relevant to your investment and sorted them in descending order of importance. In other words, the lower the ranking number, the more impactful we rate the error of reasoning. According to our assessment, thinking error no. 1 has the greatest (negative) impact on your investment.

• Misconception no. 13: Black swan
• Misconception no. 12: Survivorship bias – survival fallacy
• Misconception no. 11: Home bias – home market tendency
• Misconception no. 10: Confirmation bias – confirmation error
• Misconception no. 9: Action bias – overactivity
• Misconception no. 8: Information bias – information overload
• Misconception no. 7: “Regression-toward-the-mean” ignorance – ignorance of the regression effect
• Misconception no. 6: Social proof – herd instinct
• Misconception no. 5: Hindsight bias – backsight error
• Misconception no. 4: Loss aversion
• Thinking error no. 3: Overconfidence bias – overestimation effect
• Misconception no. 2: Sunk cost fallacy
• Misconception no. 1: Misjudging exponential growth

In the following chapters, we present each of these errors of reasoning. At the beginning, you will receive a general explanation in each case, followed by system-related practical examples and a conclusion with tips on how you can avoid the corresponding error in thinking.

And one more thing: We look forward to your feedback in the comments below, regardless of whether you agree or disagree with our assessment.

Presentation of the individual thinking errors with explanations, examples and tips

Misconception no. 13: Black swan

We start our ranking with the Black Swan – the “Who would have thought it?” thinking error. According to Nassim Taleb, author of the bestseller “The Black Swan”, this is an unthinkable event with a huge impact on our lives. There are positive and negative black swans.

The coronavirus crisis, for example, has brought both positive and negative black swans. On the negative side, the lockdown forced all restaurants, fitness centers and other meeting places to close – often with drastic financial consequences for owners and staff. On the other hand, coronavirus had a positive impact on all investors, who topped up their equity ETFs during the coronavirus crash, which lasted just a few days, and thus benefited from around 30% lower prices.

Another negative black swan was embodied by our once national airline Swissair. On October 3, 2001, its shares plummeted by 96%. A short time later, one of the most traditional Swiss companies went bankrupt. As an investor in individual shares, such black swans in the form of total losses on the stock market occur more frequently than is generally thought.

In addition to Swissair, there are countless other once highly praised “hero-to-zero” companies that had to pull the plug and cease trading practically from one day to the next. Other examples include the global investment bank Lehmann Brothers, the energy giant Enron and the ambitious German payment processor and former stock market darling Wirecard.

Conclusion: Invest based on rules, diversify your investments broadly and always keep a cool head during stock market turbulence. This will not protect you from crashes and the associated book losses. However, unlike investments in individual stocks, you will not suffer total losses as a result of company bankruptcies.

Misconception no. 12: Survivorship bias – survival fallacy

This error of reasoning systematically overestimates the probability of success. This error is particularly common with actively managed investment funds. Financial publications regularly publish rankings of the best-performing funds of their advertising clients. Great moments for the financial sector and its marketing offices, which naturally exploit this good news with relish on all media channels. Who could blame them?

So what is the problem? The observation period is too short. It is no great feat to beat the index in the short term over one, two or three years. In the longer term, however, only very few actively managed funds manage to do this – after deducting costs. Worse still – and now we come to the core of this bias: the majority of funds are in the investment graveyard. In other words, fund providers are constantly sifting out their loser funds for lack of success, thus removing them from the market – and from our memory. Of course, these negative stories do not appear in the glossy brochures, but take place in the shadows. What remains are the few “winning funds” pushed by the media.

This bias leads us to mistakenly assume that successful actively managed investment funds are teeming with them. In other words, successful products that easily manage to beat the index.

However, the fact is that an overwhelming majority of actively managed funds have an unfavorable risk/return ratio. This means that, after deducting costs, they do not manage to outperform the index (in relation to the risk taken) or a corresponding ETF over the long term, i.e. over ten or more years.

Conclusion: Don’t be fooled by success stories from the financial sector. Also remember that the winning funds of the past are often the flops of tomorrow (see also misconception no. 7). When choosing an investment product, concentrate on the really relevant question: What was the risk-adjusted, long-term return after deduction of all costs for your chosen or desired fund compared to the appropriate index (benchmark)? If you come to the conclusion that you cannot achieve the market return (index), buy one or more tried and tested index-based ETFs. If you find it difficult to choose, take a look at our independent ETF comparison “Best ETFs Switzerland and globally: And the Winner is…”.

Misconception no. 11: Home bias – home market tendency

Home bias refers to the tendency to overweight investments in the home market. Put simply, this means that Swiss women prefer to invest in the “SMI”, Germans in the “DAX” and Americans in the “S&P 500”. The reasons for preferring the domestic market are manifold and, at least at first glance, understandable: more confidence in local companies, a better information base, lower transaction costs, no exchange rate risks.

However, scientific studies show that global diversification offers the best risk/return ratio for your investment in the long term. This finding does not rule out the possibility that the domestic SMI index, for example, which focuses on a small number of Swiss stocks, may outperform the broadly diversified MSCI World index over one period or another. However, the risk you take is higher.

This is because the performance of the SMI is heavily dependent on a small number of stocks. The top 3 positions in the SMI, Nestlé, Novartis and Roche, account for more than 55%. This means that if just one of these stocks weakens, the entire index weakens. The broadly diversified MSCI World, with around 1,600 stock corporations from 23 industrialized countries including Switzerland, is different: the top 3 Apple, Microsoft and Amazon account for just 11% of the total market capitalization of the MSCI World.

Conclusion: Practice patience and use the power of diversification in the long term. This will give you the only free lunch in your investment. In other words, an advantage that does not have to be paid for with a disadvantage. This is reflected in an optimal risk/return ratio.

Misconception no. 10: Confirmation bias – confirmation error

For Dobelli, confirmation bias is the father of all thinking errors. This is probably why he is the only person to devote two chapters to it in his book “The Art of Clear Thinking”, which is well worth reading. In our book, this thinking error makes it into the top 10.

What is it about? In confirmation bias, we tend to interpret new information in such a way that it is compatible with our beliefs, e.g. in the form of theories or world views. We filter out new information that contradicts our existing views. This is dangerous because “facts do not cease to exist just because they are ignored”, as the British writer and philosopher Aldous Huxley once said.

Let’s assume that you are firmly convinced that the asset class “shares” is highly dangerous, that simple investors are being badly ripped off in the stock market casino and that they will therefore only suffer losses sooner or later. If you are subject to confirmation bias, you will interpret and filter all new stock market news in such a way that your beliefs are confirmed. This will further reinforce your negative “stock market world view”.

Conclusion: Write down your beliefs in money matters. Then dedicate yourself to the necessary and laborious task of critically questioning your beliefs in this regard by looking for counterexamples (disconfirming evidence). If you want to take even more effective countermeasures, ask your most critical acquaintances to “challenge” your beliefs and, if necessary, to stomp them into the ground.

Misconception no. 9: Action bias – overactivity

This mistake often happens in new or unclear situations. We then feel the impulse to do something hastily, anything – even if it is to our detriment.

Stock market newcomers in particular tend to constantly tinker with their portfolio – for example with superfluous trades. This causes unnecessarily high costs.

The action bias stems from our hunter-gatherer days, when activity was superior to inaction in most situations. What’s more, decisive action was essential for survival at that time, while patient waiting could be fatal. Just think of the sabre-toothed tiger lurking behind the bushes.

Conclusion: In unclear situations, such as those we are currently experiencing with the war in Ukraine and the associated upheavals (inflation, electricity crisis, etc.), it is worth taking a calm, rational and rule-based approach to the stock market. We believe that an effective tool against action bias is a written mission statement about your own finances and an asset allocation tailored to your personal risk profile. Such instruments give you security in turbulent stock market times. In addition, robo-advisors can be useful for you, allowing you to keep your portfolio in autopilot mode and thus protect it from harmful overactivity.

Either way, you can curb your impatience by taking the stock market guru André Kostolany, who died in 1999, and his stock market wisdom to heart: “Buy shares, take sleeping pills and stop looking at them. After many years you will see: You are rich. “With the equity ETFs we favor, we immediately agree with this “buy-and-hold” approach. However, in order to avoid total losses, we strongly advise against doing nothing or staying dormant with individual shares. Because history teaches us that individual companies can go bust more often and more quickly than is generally thought. (see also misconception no. 13).

Misconception no. 8: Information bias – information overload

Information bias is the mistaken belief that more information automatically leads to better decisions. As investors, we are confronted with vast amounts of irrelevant and/or incorrect financial news every day.

Here is a small selection on the Swiss SMI share index as at August 29, 2022: “Heavyweights prevent heavier losses”, “Three negative signals in a row” (both from Finanz und Wirtschaft), “Struck: Is the SMI now heading for its low for the year?” (Cash), “SMI – Entry opportunity at the support level” (Onvista). While the first headline is irrelevant but still correct, the other three are the work of so-called chart technicians. They want to predict future developments on the basis of previous price trends, which is complete nonsense from a scientific point of view. In his book “Souverän Investieren mit Indexfonds und ETFs”, which is well worth reading, the author Kommer dismissed such hocus-pocus as “financial pornography”.

Conclusion: Try to get through life with the minimum of stock market information, true to the motto “What I don’t know won’t make me hot.” It’s better to focus on the relevant basics of investing, as we have summarized here in eight lessons. In addition, read or listen to one or more reputable non-fiction books (see our recommended reading in this chapter). This will help you build a stable and well-founded mindset in financial matters, which will protect you from uncertainty and irrational, harmful investment decisions.

Misconception no. 7: “Regression-toward-the-mean” ignorance – ignorance of the regression effect

Regression to the mean is a somewhat unwieldy term from the world of statistics. It describes the phenomenon that after an extreme measurement, the subsequent measurement is closer to the average. Extreme performances therefore alternate with less extreme ones.

Applied to the stock market, the regression effect means that the most successful equity ETF of the last three years – in terms of performance – will hardly be the most successful ETF of the next three years.

If we ignore this statistical principle on the stock market, we are engaging in harmful performance chasing, a variant of market timing. Driven by “Fomo” (“Fear of missing out”), we chase returns. In other words, we buy at peak prices in overheated markets, which is the absolute loser’s formula on the stock market.

But why do we behave like this? This error in thinking is probably due to our human instincts: We are magically attracted to winners.

Conclusion: A simple and effective way to take the principle of regression to the mean into account is to periodically carry out rule-based rebalancing based on predefined target values. This allows you to invest anti-cyclically and not in markets that are already hot with a high crash potential.

Misconception no. 6: Social proof – herd instinct

Social proof refers to our still deeply rooted herd instinct. But why do we tick like this? Because this group-oriented behavior has proven to be a good survival strategy in our evolutionary past. Think of the sabre-toothed tiger again. Anyone who hesitated and did not flee with their fellow tigers was eaten and disappeared from the gene pool.

Today and in relation to the stock market, social proof is one thing above all: the great evil behind bubbles and crashes.

Conclusion: We believe the best recipe against social proof is a solid financial education and, of course, awareness of this error in thinking.

Misconception no. 5: Hindsight bias – backsight error

In hindsight, a development always seems completely plausible and predictable. A big mistake: after all, who correctly predicted the 2008 financial crisis or the 2020 coronavirus crash? Nobody.

According to Dobelli, the backsliding error is one of the most persistent thinking errors of all. He also describes it as the “I’ve-always-known-it phenomenon”. According to studies, even people who are aware of this thinking error fall into the trap just as often as everyone else.

But why is the hindsight bias so dangerous for us investors? Because it makes us believe that we are better forecasters than we actually are. This makes us overconfident on the stock market and tempts us to make the wrong decisions.

Conclusion: Dobelli advises us to keep a diary of our economic forecasts so that we can remind ourselves of our misjudgements in black and white at any time. We see a less costly but no less effective measure in a passive, rule-based, forecast-free and speculation-free investment approach, as we advocate on our blog and invest accordingly ourselves.

Misconception no. 4: Loss aversion

If you look at the record-breaking expenditure on insurance by Mrs. and Mr. Swiss, we are probably particularly affected by this error in thinking. What is it all about? Investors tend to react more sensitively to negative price developments than to positive ones. Price losses of 20% therefore generally have a greater impact on us than price gains of the same amount.

Loss aversion is also reflected in overly cautious investment behavior. Risk-averse investors feel most comfortable with their (interest-free) savings account, while avoiding risky asset classes such as equities.

Incidentally, in our evolutionary past, the aversion to loss and risk was even more pronounced than it is today. All it took was one stupid mistake and you were out of life. People who were careless or too risk-averse died before they could pass on their genes to the next generation. The cautious survived – and we as their descendants.

We see the extreme variant of loss aversion in the so-called zero-risk bias. Is there such a thing as zero risk in financial matters, i.e. total security? Of course not. Even if you sell all your equity ETFs and transfer the money to a savings account, your assets are not safe. The bank could go bust, inflation could eat away a small chunk of your savings every day or a currency reform could cause nasty surprises.

Conclusion: Risks are just as much a part of life as your investment. From a rational point of view, you are well advised to hedge against risks that threaten your existence, bear all other risks and benefit from long-term returns that exceed the inflation rate.

Thinking error no. 3: Overconfidence bias – overestimation effect

Almost there! We now come to the medal ranks: Bronze is dedicated to our overestimation of ourselves. This mental error consists of systematically overestimating our knowledge and our ability to predict. This psychological pitfall is facilitated by previously experienced, accidental successes (“beginner’s luck”).

In the late 1990s, many investors poured their entire savings into internet stocks. Fueled by initial successes, they imagined they had masterful stock-picking skills and were able to select successful stocks of the future. A big mistake: the entire market simply went up at that time. And when the dotcom bubble burst, the financial tragedy of numerous speculators was perfect.

Surprisingly, according to Dobelli, experts such as economics professors suffer even more from overconfidence. With serious consequences if we blindly follow the forecasts of these professionals in our investments. This uncritical and harmful belief in authority is also known as “authority bias”.

Conclusion: Ignore forecasts or at least always be skeptical of your own market assessments as well as those of so-called stock market professionals. Especially when it comes to short-term forecasts. In our opinion, the only two forecasts that you should make as a rational equity investor are

• In the long term, the market economy will endure and
• From a global perspective, more and more people will be able to improve their standard of living.

If you share these two views, then in our opinion there is nothing to be said against a long-term investment in one or more passive, broadly diversified equity ETFs.

Misconception no. 2: Sunk cost fallacy

Every business administration student is warned about this error in thinking, to which we award the silver medal. What’s the point? Whether you are a company director or a private investor, you all have a tendency to continue to take into account the sunk costs of previous bad decisions when making your current decisions.

In this way, further costs are accepted for unsuccessful projects (“throwing good money after bad”) instead of terminating the project and admitting the bad investment. In other words, if you put a project to the test today, you should only consider the future cost-benefit ratio in your decision-making, not the past costs that have already been sunk. Because these are irretrievably lost.

Example: You have been invested in an expensive, actively managed equity fund for many years. Let’s call it “The World’s Best Stocks Premium Fund”. You realize that due to the high costs, the performance of this investment lags significantly behind the benchmark of the MSCI World Index in a multi-year comparison. What do you do? As a rational investor, you pull the ripcord: You stop the high costs, accept any exit fees and invest in a low-cost (passive) equity fund instead. Incidentally, you should also do the same with overpriced brokers.

Conclusion: Consider sunk costs as a valuable, albeit sometimes expensive, lesson and act according to the motto “Better an end with horror than a horror without end”.

– Partner Offer–

– – – – –

Misconception no. 1: Misjudging exponential growth

Gold for exponential growth! This choice may surprise you. But exponential growth, which is reflected in the compound interest effect in your investment, is so powerful that we see misjudging it as the biggest psychological pitfall. In your investment, compound interest is your closest ally and an unparalleled long-term performance booster, as we will see later.

Albert Einstein is said to have once said: “The compound interest effect is the eighth wonder of the world. Those who understand it earn from it, everyone else pays for it.” In contrast to linear growth, which we understand intuitively, exponential growth is beyond our imagination. This is because our evolutionary past has not prepared us for it. The experiences of our ancestors were predominantly linear. For example, those who spent twice as much time picking berries brought in twice the harvest.

For a better understanding, here’s a scenario: generous as you are, you want to invest 10,000 francs for your underage offspring (alternatively, of course, it could be the godchild). You examine three investment options over an investment horizon of 40 years.

Option A is a fixed-interest security in the form of a corporate bond with an annual interest coupon of 8%. Option B is an equity ETF “MSCI World” with expected price increases of 8% per year on average. Option C is an actively managed “global equity fund” from your house bank with an expected return of 6% (market return less 2% management fees & co.). We leave out inflation and taxes for the sake of simplicity. What would you choose?

Bravo, you probably guessed B and thus made the “right” choice (see Fig. 2).

What you may not have expected, however, are the huge differences in the increases in value of the three investment options (see Fig. 3).

Let’s first compare options A and B. Both pay interest at 8%. The decisive factor here is not the amount of interest, but the exponential growth of option B. This is because the ETF is subject to the compound interest effect, i.e. the interest-bearing base increases by 8% each year: CHF 10,000, CHF 10,800, CHF 11,664 and so on. With the bond, on the other hand, it remains constant at CHF 10,000, which is why the interest income also remains stable over the years (linear growth).

What is astonishing is that thanks to the compound interest effect, the ETF beats the bond not just by 20, 30 or 50%, but by 548%!

If we compare options A and C, it is noticeable that compound interest is more powerful than the interest rate. Despite the lower interest rate (8% vs. 6%), option C performs 190% better than option A.

However, equity-oriented investors should be interested in the considerable difference in performance between Option B and C. The same asset class, but a supposedly small interest rate difference of 2%, based on higher ancillary costs, means a CHF 114,388 reduction in income after 40 years for the actively managed investment.

Conclusion: Use the power of compound interest in your investment. Invest passively rather than actively and choose a low-cost broker that is suitable for you in order to keep the ancillary costs of investing as low as possible. Because these ongoing costs have a drastic impact on your assets in the long term due to the negative compound interest effect, as the comparison between option B and C has clearly shown. Last but not least: When it comes to growth rates, it’s better not to rely on your gut feeling, but on your calculator or the compound interest formula: [=initial investment*(1+interest/100)^holding period)-initial investment] or, as an example for option B: [=10000*(1+8/100)^40-10000] (Excel)

Literature references (incl. book tips)

In our reading of various books on the subject of bias or psychological thinking errors, one name has been quoted particularly frequently: Daniel Kahnemann, psychologist, Nobel Prize winner and expert in the field of behavioral economics. He has written many scientific works on cognitive biases, such as his well-known book “Think fast, think slow”. We have compiled this and other works that inspired us when writing this article below:

• Dobelli, Rolf, The art of clear thinking, 2011
• Dobelli, Rolf, The art of acting wisely, 2012
• Housel, Morgan, On the psychology of money, 2021
• Kahnemann, Daniel, Think fast, think slow, 2012
• Kommer, Gerd, Investing confidently with index funds and ETFs, 2018
• Taleb, Nassim Nicholas, The Black Swan, 2007

We think all the books mentioned are worth reading and recommending. If you want to find out more about psychological pitfalls (also outside the financial sector) in an entertaining way, then the two bestsellers by Swiss author Rolf Dobelli are the perfect choice. The (audio) book by US author Morgan Housel, in which he vividly explains in 20 short stories why we repeatedly make bad financial decisions, also offers lighter fare.

The other three works are somewhat less entertaining, but they offer more scientific depth. Among these, we consider Kommer’s “Souverän investieren…” in particular to be a must-read for anyone who wants to acquire a rational, science-based buy-and-hold investment approach. Incidentally, this standard work is available for free on Spotify as an audio book, both in the original and in the abridged version for beginners, which is also highly recommended.

This might also interest you

Disclaimer

Disclaimer: This article does not constitute an investment recommendation, but is for your information only.