Behavioral Finance is a field of study that combines psychology and economics. It argues that as human beings, investors are not always rational or logical. Humans are subject to personal beliefs and/or biases that may lead to irrational and emotional decisions. These beliefs and emotional reactions can have a significant impact on your investments and financial goals, as they sometimes drive decision-making. Acknowledging and understanding these biases and taking steps to avoid them are the best way to make sure you have a strong, diversified portfolio.
WHAT YOU NEED TO KNOW
The following are some of the common biases that cause investors to make illogical investment decisions:
1. Confirmation Bias:
Confirmation bias is the tendency to seek out information that supports our pre-existing ideas. When picking investments, we often look for information on products that we want to hear and would justify our decisions to select them. This can be dangerous and costly.
How to Avoid this Bias: Take time to consider all of the information available to you before making a decision. Ask your advisor to help you gather data and make educated investing decisions.
Anchoring occurs when investors fixate on past prices and information. It is easy to get “anchored” to the price of a stock or the level of the market, focusing on what we think we should get rather than what we can reasonable get. This can cause investors to reject rational investment decisions and subsequently lead them to hold onto losing investments.
How to Avoid this Bias: Thinking critically is your best defense against anchoring. Your advisor can help you with this. Allow him/her to play the role of devil’s advocate; listen to different perspectives and let yourself see the information you may be missing. Successful investors base their decisions on many relevant factors, not just one piece of data.
3. Mental Accounting:
Mental Accounting is the term used to explain our tendency to assign different money different functions. We tend to allocate our assets in sometimes detrimental and irrational ways. For example, we may consider our tax return “bonus money”, and therefore spend it more frivolously, when it could have been applied to debt or deposited into retirement savings. This type of thinking can hold you back in reaching your financial goals.
How to Avoid this Bias: Money is money, and should be treated as such no matter the source. Ask your advisor for help organizing your financial priorities and treat all money as earned income.
Being an overconfident investor makes you think you know more than you really do. Sometimes all it takes is one big win, and we become irrational with our investment decisions. You may begin to trade more rapidly, which is rarely worth the costs, or start under diversifying in hopes of hitting it big again.
How to Avoid this Bias: Recognize that there is a point where you can be too involved with your investments and it can cost you big time. Be sure that the decisions you are making are driven by reason, not emotion.
5. Loss Aversion:
On the opposite end of being overconfident, is suffering from loss aversion. Loss aversion is when we focus so heavily on not losing money, we neglect the fact that we could be making money. This type of thinking can cause us to have unbalanced portfolios, keep us from unloading unprofitable investments, and hold us back from realizing our financial potential!
How to Avoid this Bias: Feeling the pain of loss is a completely human experience and it is only natural that we want to avoid it at all costs. Try formulating a plan with your advisor on what you will do if your investment loses, even before it does. That way you have a rational plan in place that will keep you from making emotional investment decisions that could hurt your portfolio further.
The Bottom Line
We all possess a unique combination of rational and irrational traits when it comes to investing. The good news is, being self-aware and educating yourself can help you overcome any hurdles you may face. The first step is talking to a financial advisor. An advisor can help you moderate and adapt to your biases, keeping you on track to meet your financial goals.