Imagine you received a windfall of $1,000. Would you spend it frivolously? Would you put it in your savings account or invest it? It comes as no surprise that most people would opt to spend the windfall rather than save it or invest it, even if they are ordinarily frugal when it comes to spending decisions.
People often make financial decisions because of emotionally-based behavioral biases towards money, personal finance, and investing. This is where behavioral finance comes into play. Behavioral finance is a field of study that focuses on psychological factors that influence managing and investing our money.
Through research, it has been discovered that we use several mental shortcuts to make complex decisions, including those regarding money. This can lead to biased judgments and indiscretions when it comes to personal finance. People are usually unaware of their behavioral biases that influence their ability to make decisions, especially when it comes to investing and money.
Here are four common biases that can affect your relationship with money and tips on avoiding them.
The overconfidence bias is the tendency to see ourselves as having more information than we actually do or seeing ourselves as better off financially than we really are.
Overconfidence can cause issues when it comes to investing and spending money. Those who are overconfident often do not manage and control risk properly.
So why is this a problem? The answer is simple. Let’s say you’re an overconfident investor. You may overestimate your knowledge and abilities, which can lead to poor or impulsive decisions. You may think that you are beyond losing, but in reality, the markets are notably unpredictable.
How to avoid overconfidence: If you’re just starting as an investor, it’s best to consult with a professional and establish your investing strategy. A passive investing strategy may be worth consideration, rather than trying to time the markets. Ultimately, active traders tend to do worse than those who buy and hold in the long run.
Everyone who has invested has done this at least once. You were absolutely positive that a specific stock was value-priced and had the minimal potential for decline. You completed the trade, but it slowly worked against you, and you didn’t sell when the loss was small. You continued to hold and refused to sell until the stock lost the majority of its value.
People will typically try to avoid the feeling of regret whenever possible, and some will even go to incredible lengths to avoid taking responsibility for the decision that led them to feel regret. For some, it is easier to pretend the loss doesn’t exist to avoid dealing with regret.
How to avoid Loss-Aversion: Set trading rules for yourself and stick with them. For example, exit the position if a stock trade loses more than a certain percentage of a comparable benchmark.
Rules help you take the emotion out of your investment decisions.
The anchoring bias is a cognitive bias that causes us to rely on information from the past, like the price you paid for a stock. If the price drops and you find yourself waiting for the price to return to what you originally paid before you sell, you have anchored to the original price. This can lead to issues because those with an anchoring bias will usually place too much value on an initial piece of information to make different judgments.
This bias can influence decisions such as when to buy or sell an investment when it comes to investing. People with this bias run the risk of holding on to stocks longer than they should because they’ve held onto the higher price than when they originally purchased it.
How to avoid anchoring: Take your time research before making decisions. Having an assessment and a complete understanding of an asset’s price can help reduce an anchoring bias. Be open to new information and make sound decisions based on facts.
Herd bias is “following the crowd,” or having the mentality that you should follow what other people are doing in the stock market instead of making your own decisions based on financial data. This is a common bias for investors who tend to invest in the same stocks as their friends or colleagues, even if there is a high risk involved.
People follow the herd because it feels safe. In today’s day and age, many people also have FOMO – the Fear of Missing Out. If someone you know is making money investing in penny stocks or cryptocurrency, it feels unsettling to sit by the wayside while others are making money from the risk they chose to take. The herd behavior bias can also cause unprecedented setbacks. It can end up creating “bubbles” such as the Dutch Tulip Bubble or the tech stock bubble from the late 1990s and increase the price of an asset to absurd levels.
How to avoid herd bias:
- Always choose your investments carefully.
- Research a company’s fundamentals to see if it is a solid investment, rather than just following what friends say or what you see in the news.
- Be suspicious about stocks marked as “hot” and promoted on internet forums and blogs.
Recognizing some of these biases in your relationship with investing and money can be a hard pill to swallow. Understand that the best way to avoid these potential emotional traps and financial errors is being aware that they exist, establish trading rules for yourself, and having a financial plan in place to help guide you toward making logical investment decisions. While you can’t avoid behavioral biases altogether, you can minimize their impact on your finances.
This content is developed from sources believed to be providing accurate information, and provided by Spectrum Management Group. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.