Bias is broadly defined as an inclination or predisposition for someone or something over another. It exists everywhere, including in how investors approach their financial decisions and the management of their portfolio.
A certain amount of bias is almost certainly unavoidable. But cognitive biases that you’re not aware of can garner a negative impact on investment decisions. Here, we explore some of the more common biases that shape our approaches to money. Plus, see below for some basic tips on how to rein them in.
Where do biases come from?
Bias, and being biased, is a very normal and human condition. Researchers believe that some biases are innate and evolutionary, while others are social and learned. Other experts also tell us that we can develop biases through things as simple as wishful thinking.
Again, almost regardless of the target, a bias means our conscious minds can’t see and appreciate information that contradicts our held assumptions. “De-biasing,” as psychologists and social scientists refer to it, is a challenge as a result. But because biases can do plenty of damage to ourselves and those around us, it’s a worthwhile effort.
How cognitive biases impact investment decisions
Investors tend to fall into a few common traps when it comes to biases.
Situation 1: When losses evoke stronger feelings than wins
Loss aversion is a big one for investors. In simple terms, this means that you’re more likely to feel the pain of things going wrong rather than satisfaction or reassurance from investments that are doing well. It also means that you’d probably rather avoid a loss than acquire a gain – a challenge when you’re investing in the stock market.
Understanding your risk tolerance by quantifying it can help put this bias into perspective. At RBG Wealth Advisors, our Risk Number calculator will help you visualize the level of risk you want, how much risk you currently have in your portfolio, and how much risk you need to take to reach your goals.
Situation 2: When you’re trying to keep up with the crowd
Herd behavior bias, otherwise known as the “bandwagon effect,” is when your investment decisions are primarily based on what is trending or popular, perhaps from a fear of being left out of something you see trending because of an influencer. We typically tell clients not to get too bogged down by the allure of trends like these. Assuming something does work for your favorite NFL player, this doesn’t mean it will work for your portfolio, too.
Similarly, a confirmation bias is when we assume that new evidence presented to us confirms our existing beliefs and attitudes. We subsequently seek out information that supports those beliefs. Even if there’s evidence out there, for example, that a stock an investor has chosen is a sinkhole riddled with problems, an investor may prefer the comfort of accounts that the investment is promising.
Situation 3: When you can’t see the forest for the trees
Information biases lead us to evaluate a large amount of detail even if it isn’t relevant to our specific situation. An investor might fall into this trap by parsing through every article in the Wall Street Journal or Kiplinger’s, while having a hard time distinguishing what they should and should not pay attention to. One example of this could be panicking about a short-term stock drop in the market, when your investment plan has medium and long-term goals.
Confirmation and information biases, examined together, form a fine balance. While you don’t want to cut yourself off from important details that could challenge or even refine the information you already have, it’s not helpful to obsess and worry that every article or piece of information is speaking directly to you or your decisions.
Changing your perspective about investing, even on a micro scale, can make a big difference. For advice specific to your situation, personality, and thoughts toward money, it’s best to schedule a consultation with your financial advisor.
Our goal at RBG Wealth Advisors is to ensure your investment portfolios meet financial planning needs, while also maximizing efficiency. If you’re interested in learning more about how we might be able to help you achieve your goals, reach out today for a consultation.