How Behavioural Biases Cost Investors Billions
Aug 7
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Introduction:
Traditional economic thought assumes investors are rational. This means that investors logically process data and make decisions with a focus on maximizing returns without taking unnecessary levels of risk and speculation. However, real-world investing proves otherwise. The presence of emotions in the average human being means that they don’t act like robots and instead act in unpredictable ways. Namely, people can panic in a moment of fear or chase hype and risk out of pure greed. Humans can overestimate the value of an investment or be overconfident in their decisions. These mental traps are known as behavioral biases.
When these behavioral biases are repeated by the millions of investors around the world, they result in massive losses in wealth and mispricing in the markets.
This article will cover what a behavioral bias is and provide examples of different types of behavioral biases.
What are Behavioural Biases:
Behavioral biases are systematic patterns of deviation from rationality. They're the shortcuts our brains take to save time, conserve energy, or avoid pain. While these mental habits can be helpful in everyday life, they become dangerous in high-stakes environments like the stock market.
In investing, behavioral biases can present themselves as:
Overreacting to news headlines
Buying during market highs out of fear of missing out
Holding on to bad investments to avoid admitting loss
The Big Five Biases that Cost Investors Money
1.Loss Aversion:
Loss aversion is the tendency to fear losses more than you value gains.
Research has suggested losing money may be as much as twice as painful as the pleasure gained from making the same money.
This leads investors to:
Hold on to losing stocks with the hope of a recovery.
Selling winning stocks too soon because of the fear of losing the profit.
Avoid buying stocks on a dip or a crash.
2.Overconfidence Biases
Overconfidence leads people to believe they have superior knowledge or skill, even when they don’t. In investing, it shows up when:
Investors trade frequently, sometimes hourly, convinced they can time the market.
They overweight individual stock picks, believing they can outperform experts.
They don’t diversify because they believe their picks are near perfect.
Overconfidence also leads to risk underestimation, especially in bull markets. The danger here is that most investors who overtrade their peers tend to underperform their peers who just buy and hold or just dca. This applies even to hedge funds and large asset managers. It is very rare for a trader to outperform the market in the long run.
3. Herd Mentality
Humans inherently feel safer in groups. In investing, this instinct shows up as herd mentality: doing what others are doing simply because they're doing it.
Herd mentality is one of the primary reasons for both bubbles and crashes in the market.
A bubble is formed when investors speculate that the price of the asset will be significantly higher in the future, so they invest in the asset in the present. This brings speculators into the asset and then eventually brings investors experiencing FOMO ( The fear of missing out), which drives the price of the asset much higher than the intrinsic value of the asset. When the asset then crashes back to its intrinsic value, it is known as the bursting of a bubble.
Real-life examples include:
In the late 1990s, the whole world was heavily fixated on internet stocks, which led to record gains in the internet sector of the stock market. Most of the companies at the time had no profits or, in some cases, no product but were still driven higher through speculation.
In 2021, GameStop’s stock surged not because of earnings or innovation, but because retail investors rallied around it on Reddit.
Herding leads investors to follow the market at the wrong time and can result in material losses for investors.
4. Anchoring
Anchoring bias is the tendency to fixate on specific reference points—usually irrelevant ones—when making decisions.
In investing, the most common anchor is the purchase price of a stock.
For instance, if a person sees a stock at $500 and then watches the price of the stock collapse to $300, it creates the impression that the stock is trading at a discount and can lead to purchasing the stock even if the fundamentals of the company are deteriorating.
Anchoring biases can also cause investors to avoid buying stocks that are higher than when they first saw it. This can lead to the investor missing out on high potential returns in the future if the company is fundamentally improving.
Anchoring blinds investors to present realities and future prospects. A stock’s past price tells you nothing about its future value. But anchoring causes investors to base sell decisions not on company fundamentals but on price-based benchmarks.
5. Confirmation Bias
Confirmation bias is when people only seek out or accept information that supports their existing beliefs, while ignoring evidence that contradicts them.
In investing, this looks like:
Reading only positive analysis on a stock you already like
Following financial influencers or YouTubers who agree with your views
Dismissing expert warnings or uncomfortable data
This bias reinforces poor investment decisions and creates echo chambers, especially in the age of social media. Investors begin mistaking groupthink for validation.
What is the Estimated Cost of these Biases
These aren’t just theoretical concepts—they translate into real, quantifiable losses.
Investor Returns vs. Market Returns
According to Dalbar's 2023 Quantitative Analysis of Investor Behavior:
Over the past 30 years, the S&P 500 returned about 10 percent annually
The average equity investor, however, earned only around 6 percent annually
That 4 percent gap doesn’t come from fees or taxes alone—it comes primarily from poor timing decisions driven by behavioral mistakes.
Over 30 years, $10000 invested at:
10 percent annual return = $174000
6 percent annual return = $57400
The behavioral cost? Over $100000 in lost returns.
Real-Life Case Studies
In 2008, as markets crashed, retail investors panicked and sold at record levels. Those who held on or bought more during the downturn earned huge gains when the recovery began in 2009. Many who exited missed the entire rebound.
During the COVID-19 crash in March 2020, investors again rushed to sell. But markets rebounded by over 60 percent by year-end. Those driven by fear missed one of the fastest recoveries in history.
The GameStop mania of 2021 saw many first-time investors jumping in as the stock soared. When prices collapsed, many were left with massive losses—victims of herd mentality and overconfidence.
