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When it comes to money and investing, there are many factors that contribute to the “how” and “why” of important decisions. According to many Behavioral Finance studies, our different personalities traits & preferences, along with a range of emotional and mental behavioral biases, have a strong impact on the way we invest.
Investor Personality Types
There are 4 different types of investors, according to the CFA Institute,* each with their own distinct behavioral biases. Understanding your own investor personality type can go a long way toward helping you determine and meet your long term investment goals, as well as producing better returns.
Which of these profiles best describes you?
Preservers are investors who place a great deal of emphasis on financial security and on preserving wealth rather than taking risks to grow wealth. Preservers watch closely over their assets and are anxious about losses and short-term performance. They may also have trouble taking action for fear of making the wrong investments decisions.
Accumulators are investors who are interested in accumulating wealth and are confident they can do so. Accumulators tend to want to steer the ship when it comes to making investment decisions. They are risk takers and typically believe that whatever path they choose is the correct one. Accumulators have frequently been successful in prior business endeavors and are confident that they will make successful investors as well.
Followers are investors who tend to follow the lead of their friends and colleagues, a general investing fad, or the status quo, rather than having their own ideas or making their own decisions about investing. Followers may lack interest and/or knowledge of the financial markets and their decision-making process may lack a long-term plan.
Independents are investors who have original ideas about investing and like to be involved in the investment process. Unlike Followers, they are very interested in the process of investing, and are engaged in the financial markets. Many Independents are analytical and critical thinkers and trust themselves to make confident and informed decisions, but risk the pitfalls of only following their own research.
The Psychology Of Investing Biases
Behavioral biases affect us all as investors and can vary depending upon our investor personality type. These biases can be cognitive: a tendency to think and act in a certain way or follow a “rule of thumb.” Biases can also be emotional: a tendency to take action based on feeling rather than fact.
According to a study done by H. Kent Baker and Victor Ricciardi on How Biases Affect Investor Behavior , here are 8 biases that can affect investment decisions:
Anchoring or Confirmation Bias: First impressions can be hard to shake because we tend to selectively filter, paying more attention to information that supports our opinions, while ignoring the rest. Likewise, we often resort to preconceived opinions when encountering something, or someone, new. An investor whose thinking is subject to confirmation bias would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it.
Regret Aversion Bias: Also known as loss aversion, regret aversion describes wanting to avoid the feeling of regret experienced after making a choice with a negative outcome. Investors who are influenced by anticipated regret take less risk because it lessens the potential for poor outcomes. Regret aversion can explain an investor ‘s reluctance to sell “losing” investments to avoid confronting the fact that they have made poor decisions.
Disposition Effect Bias: This refers to a tendency to label investments as ‘winners’ or ‘losers.’ Disposition effect bias can lead an investor to hang on to an investment that no longer has any upside or sell a winning investment too early to make up for previous losses. This is harmful because it can increase capital gains taxes and can reduce returns even before taxes.
Hindsight Bias: Another common perception bias is hindsight bias, which leads an investor to believe – after the fact – that the onset of a past event was predictable and completely obvious whereas, in fact, the event could not have been reasonably predicted.
Familiarity Bias: This occurs when investors have a preference for familiar or well known investments despite the seemingly obvious gains from diversification. The investor may feel anxiety when diversifying investments between well known domestic securities and lesser known international securities, as well as between both familiar and unfamiliar stocks and bonds that are outside of a “comfort zone.” This can lead to suboptimal portfolios with a greater a risk of losses.
Self-Attribution Bias: Investors who suffer from self-attribution bias tend to attribute successful outcomes to their own actions and bad outcomes to external factors. They often exhibit this bias as a means of self-protection or self-enhancement. Investors affected by self-attribution bias may become overconfident.
Trend-chasing Bias: Investors often chase past performance in the mistaken belief that historical returns predict future investment performance. This tendency is complicated by the fact that some product issuers may increase advertising when past performance is high, in order to attract new investors. Research demonstrates, however, that investors do not benefit because performance as frequently as not fails to persist in the future.
Worry: The act of worrying is a natural, and common, human emotion. Worry evokes memories and creates visions of possible future scenarios that alter an investor’s judgment about personal finances. Anxiety about an investment increases its perceived risk and lowers the level of risk tolerance. To avoid this bias, investors should match their level of risk tolerance with an appropriate asset allocation strategy.
Which investor personality best describes you and which biases are you predisposed to?