1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #82!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio In our podcast today we will discuss how your behavioral biases sabotage your long-term investment plan.
Enjoy!
2) INVESTOR PSYCHOLOGY: HOW YOUR BEHAVIORAL BIASES SABOTAGE YOUR LONG-TERM INVESTMENT PLAN:
François Doyon La Rochelle:
So today, we will be tackling one of the most fascinating and perhaps the most frustrating parts of investing, which is investor psychology.
We have mentioned this regularly on the podcast and in many ways throughout the years, but the biggest risk to our portfolios isn’t the economy, interest rates, or price levels of the markets; most of the time, it’s us. Our behavioral biases shape how we save, how we invest, and they often lead us to make decisions that feel right in the moment, but that will hurt us in the long run.
James Parkyn:
That’s right, Francois, behavioral biases push investors to make common mistakes with their investments, like overtrading, chasing returns, or selling in a down market. That’s why understanding them is so important. You can have the best financial plan in the world, but if you let emotions or biases take over, that plan can fall apart very quickly. I would like to add, Francois, that as we publish this podcast at the beginning of the year, my experience is that investors are at their most vulnerable. At this time of year, you have an avalanche of financial media noise forecasting the future of how you should invest your money. You should ignore most of these pundits’ forecasts.
François Doyon La Rochelle:
Exactly, James, and today, we’ll help you develop insights to understand the most common biases and to avoid making bad investing decisions. So, as you just mentioned, James, what happened this year is now a fact. So those results are highly likely to lead to recency bias, a bias often mentioned on this podcast, but there are many others that we would like to cover with you today.
James Parkyn:
Yes, Francois, the field of behavioral economics has evolved dramatically over the past 25 years. There are, in fact, too many behavioral biases to cover in this podcast, but we will look at the most common that affect investors. This said, before we go ahead, Francois, I think it would be appropriate for our listeners for us to start with the basics.
François Doyon La Rochelle:
Well, James, in investing, a "bias" is an irrational belief or preference that clouds an investor's decision-making based on facts. Biases make investors deviate from logical analysis to decisions driven by emotions, habits, or social cues. There are two types: cognitive biases, which are errors in processing information, and emotional biases, where feelings override facts.
James Parkyn:
Yes, and this isn’t just theory; behavioral finance is one of the most researched areas in economics today. Researchers like Daniel Kahneman and Amos Tversky described in a 1979 paper how investors are risk-averse in situations of gain but risk-prone in situations of losses. This research is the basis of what is now known as the loss aversion bias. Daniel Kahneman won a Nobel Prize in economics in 2002 for this research. Richard Thaler, another Nobel Prize winner in economics in 2017, developed the concepts of mental accounting and overconfidence biases. Robert Shiller, another Nobel laureate, studied herding and bubbles. And Meir Statman highlighted how emotions and social factors affect investment decisions.
François Doyon La Rochelle:
Unlike traditional finance theories, like the Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT), which assume that investors are rational decision makers, this research recognizes that emotions, biases, and mental shortcuts often lead to irrational investment behaviors.
James Parkyn:
Exactly, Francois, and recent studies show that biases continue to evolve due to investor over-reliance on AI and fintech platforms. These new studies mention that technological innovation, the COVID-19 pandemic, and the rising level of retail investor activity have intensified behavioral distortions in the markets.
François Doyon La Rochelle:
In sum, behavioral finance helps us understand that investors aren’t robots; they’re humans, and that means they’re vulnerable to fear, greed, and social pressure, which explains why we often act against our own best interests.
James Parkyn:
Francois, I think we can now take a closer look at some of the main biases to show how they negatively affect investment decisions and damage investors’ long-term financial situation.
François Doyon La Rochelle:
So let’s get right into it, and let’s start with the recency bias, and I know you love that one, James.
James Parkyn:
Yes, Francois, that's a favorite of mine. Recency bias is the tendency to give extra weight to recent events or information. This leads investors to expect recent trends to continue. But for me, Francois, Recency Bias is more than just assuming a trend will continue.
François Doyon La Rochelle:
Yes, and it steers investors into taking short-term decisions that may negatively affect their long-term financial plans.
James Parkyn:
Totally Francois, over the course of my career, I have seen investors typically more comfortable taking risks in a bull market, as they expect strong performance to continue, and shying away from taking risks after a market correction or bear market, as they expect the Markets to continue dropping.
François Doyon La Rochelle:
Yes, it’s a very common behavior. I remember back in 2008-2009, a lot of people did not believe that markets would recover, and they stayed on the sidelines, and look at where we are now. This bias is like not wanting to go into the ocean after watching the movie Jaws, despite the fact that shark attacks are very rare.
James Parkyn:
Another bias that I see a lot in Francois is the overconfidence bias. This is the tendency for a person to overestimate their investing capabilities. These investors overestimate their understanding of financial markets or specific investments. They believe that because they picked a winning stock once, they can do it again. It’s the same with market timing.
François Doyon La Rochelle:
Well, yes, the overconfidence bias tricks the brain into believing that it’s possible to consistently beat the market, but as our listeners know, it’s very difficult to do so. For the average investor, overconfidence most often leads to poor portfolio performance because of excessive trading and underestimating the risks they are taking. Recent research mentions that a source of this overconfidence in today’s world is the wealth of information available online, which creates an illusion of understanding.
James, let’s now look at the loss aversion bias.
James Parkyn:
Francois, this bias was first introduced by Daniel Kahneman and Amos Tversky in 1979. According to their research, and I quote, “the torment of a loss can be psychologically twice as powerful as an equivalent gain”. So psychologically, investors have a tendency to prioritize avoiding losses over earning gains. I have seen this behavior with clients over the years.
François Doyon La Rochelle:
Yes, and Kahneman and Tversky’s research showed this bias is hardwired; it’s not just about money, it’s about emotion, and these emotions result in investors being overly conservative. In down markets, they stay on the sidelines and avoid buying stocks, or they outright sell their stock positions to protect their portfolios from further losses. They then miss out on the gains when stocks rebound. A good example of this was highlighted by the independent financial research company DALBAR in their 2023 Quantitative Analysis of Investor Behavior report. In that report, covering the year 2022, which was one of the worst years for the S&P500 Index, they measured that the average equity investor lost 21.2% compared to 18.1% for the S&P500 Index. The negative gap of 3.1% against investors was in part attributed to the loss aversion bias.
James Parkyn:
Francois, it’s a good example, and it’s a reminder that if you stay invested, you will capture all the returns Markets have to offer when they eventually recover. But if you panic and sell, you have to guess right when to get back in. The risk here is locking in permanent losses that compound over the long term.
François Doyon La Rochelle:
Indeed James. The next bias we should cover is the herding bias.
James Parkyn:
That’s another big one, Francois; this is a cognitive bias deeply rooted in our human instinct. At one point in the evolution of mankind, it was all about survival. As human beings, we are wired for fight or flight. In finance, it’s more about fear and greed. Investors make investment decisions based on what others are doing without doing their proper due diligence and research. This bias can cause investors to panic sell or take unnecessary risks in their portfolios due to the fear of missing out.
François Doyon La Rochelle:
Ah, James, the famous FOMO. The greed that drives people into buying the latest hot stocks, market trends, and often into an overvalued asset. This bias is at the root of financial bubbles. The dot-com bubble is a great example of the herd mentality. Investors bought dotcom companies because everyone else was buying them, but many of those companies did not have financially sound business models.
James Parkyn:
Again, Francois, this is a great example, and there are many others. Think of the Meme stocks and the cannabis stocks a couple of years ago. We can also mention Bitcoin and the trading frenzy around it. What investors need to do is question the rationale before making their investment decision. They could also remind themselves of Warren Buffett's famous saying: “Be fearful when others are greedy and greedy when others are fearful.”
François Doyon La Rochelle:
That’s a great quote, James. I could not agree more. The next bias to cover is the confirmation bias.
James Parkyn:
Well, that bias is when an investor will only look for evidence that supports their views.
François Doyon La Rochelle:
Yes, due to this cognitive bias, investors are inclined to search, favor, and interpret information that supports their opinion about an investment. They can even wrongly interpret some information just to confirm their belief. These investors can also reject information that challenges their beliefs.
James Parkyn:
I would add that François, algorithms embedded in social media platforms exacerbate this bias because these algorithms push out content similar to what people have recently searched for.
François Doyon La Rochelle:
The risk with this bias is that it leads investors to have portfolio concentrations in a particular stock or sector, therefore making them vulnerable to a downturn in that stock or sector. Their views on market conditions could also be distorted because they focus on the opinions of a few experts but ignore those of others.
James Parkyn:
The last bias we will discuss today is the anchoring bias. This is a cognitive bias where an investor becomes overly attached to the first piece of information they encounter during the decision-making process. This information then serves as an anchor, a reference point, which distorts subsequent judgments and prevents the objective evaluation of new data.
François Doyon La Rochelle:
Yes, that’s a trap many investors fall for particularly when they trade individual stocks. An example of this is when someone buys a stock let’s say at $20 and he refuses to sell below that price even if the outlook and fundamentals of the company have changed negatively. Another anchoring bias investor mistake involves holding on to a stock that has dropped in value and refusing to sell, until it reaches it come back to it’s historical all time high.
James Parkyn:
I would add that anchoring distorts an investor’s rational decision-making capabilities.
François Doyon La Rochelle:
So, James, we’ve covered several biases here. What do you think are the lessons for our listeners?
James Parkyn:
Well, Francois, I think that it’s a reminder that investing is as much about psychology as it is about numbers. I have a great quote from our friend Jason Zweig from the WSJ, who once said to someone who asked what he did for a living, and I quote, “I try to figure out why smart people do stupid things with their money”. This is where advisors add a lot of value for their clients. Advisors aren’t just portfolio managers; we are behavioral coaches. So I would put things a little differently: We help smart people avoid making costly mistakes with their money.
François Doyon La Rochelle:
I agree, James, and research proves the value of an advisor. Vanguard’s Advisor’s Alpha study estimates that behavioral coaching adds up to 2% in net returns annually. We will add a link to our previous blog that covered Vanguard research. And Morningstar’s Value of Advice report highlights that the greatest benefit of advice is behavioral, not technical. Their research states, and I quote, “behavioral coaching is the single most impactful thing an adviser can do, adding, on average, 150 basis points”. They continue and say, I quote again, 'emotions can be our own worst enemy, especially when the markets are volatile, and guidance from a behavioral coach can save us from panic selling and abandoning long-term financial plans.
James Parkyn:
Advisors act as guardrails for their clients. We stop our client from turning temporary emotions into permanent mistakes. The takeaway is clear: Markets will always be unpredictable, and biases will always be a factor for investors. But with awareness, discipline, and the support from a trusted advisor, investors can avoid the traps that sabotage long-term success. As you said in the intro, Francois, the biggest risk isn’t the market, it’s us. Mastering our own behavior is the ultimate edge in investing.
3) CONCLUSION
François Doyon La Rochelle:
Thank you, James Parkyn for sharing your thoughts and expertise again today.
James Parkyn:
You are welcome, François.
François Doyon La Rochelle:
Before we conclude, I would like to wish our listeners a happy holidays season.
So, that’s it for episode #82 of Capital Topics!
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Again, thank you for tuning in and please join us for our next episode to be released on January 21st. In the meantime, make sure to consult the Capital Topics website for our latest blog posts.
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