The fast-paced financial landscape can bombard you with investment information at every turn. Whether through books, blogs, news outlets, or social media, the wealth of resources available can be both a blessing and a curse. Not all of this information is reliable. Some sources may promote biased, incomplete, or even misleading advice—making navigating finances difficult.
To make sound investment decisions, you must critically assess the information you receive, even from seemingly trustworthy sources. Yes, that goes for this article too!
This is where behavioral biases in finance come into play. These biases can cloud your judgment, causing you to make suboptimal decisions if you don’t carefully consider the information at hand.
Before you read on, let me tell you a fast story. When I started my first big-boy job, my friends and family had rendered some pretty terrible advice to me. But I was too young and too naive to know what was wise and what was foolish, so I did some of this and some of that. I had to figure much of it out myself.
By the time I was 25, this is what I learned about Biases. They are dangerous. There is a temptation to see the world one way, when there is no accurate information behind that view. Such was the case for me in investing at age 25.
Here is what I learned, there are many wealthy people that become more wealthy (or maintain their wealth) by making wise decisions! As I have observed thousands of clients earnestly seeking out sound financial advice, and incorporating that advice, I have seen thousands of clients successfully build and secure wealth!
Here is what stands out to me about that….. These are all brilliant people -surgeons, architects, lawyers, endodontists, sitting down to get coaching on their money. They are not any less bright sitting down and getting coaching; I submit to you that is the intelligent thing to do! Setting aside biases and letting the true experts lead out in their space, now that is wisdom!
Of course some interest, some education, some coaching and some skepticism are all warranted, even encouraged! But allowing the experts around us to lead, I believe that is wisdom.
So, as you read on, be open to setting aside and identifying your biases! It will create an opening to manage your biases and create excellence in your life!
Let’s dive into how these biases can influence your investment approach and, more importantly, how you can mitigate their effects.
7 Behavioral Biases in Investing
When investing, your mindset and perception play a significant role in shaping your decisions. Behavioral biases in investing are systematic errors in thinking that can lead to unsatisfactory outcomes—clouded judgment, irrational choices, and inadequate investment performance.
1. Overconfidence bias
Overconfidence bias occurs when you overestimate your abilities. It can cause you to misjudge your understanding of financial markets or specific investments, often ignoring crucial data or expert advice.
This bias often leads to overtrading, which results in higher transaction costs that reduce net returns. You may underestimate market risks, overlook diversification, or believe you can alter outcomes beyond your control if you let overconfidence bias rule.
2. Confirmation bias
You might have this tendency if you seek out or value information that aligns with your existing beliefs while disregarding contradictory evidence. This bias is prone to flawed decision-making and missed opportunities.
As an investor, you may be bullish about a particular stock because of recent positive news. Confirmation bias can lead you to overestimate the stock’s future success based on past positive outcomes. By clinging to this optimistic view, you risk making decisions that might result in significant financial losses.
Remember, past performance doesn’t always guarantee future results.
3. Loss aversion
Loss aversion makes you feel the pain of losses more intensely than the good of equivalent gains. This bias may compel you to avoid risks involving potential losses, even if the potential gains are substantial. You might stick to low-risk, low-return investments or avoid new opportunities altogether.
The hidden cost of loss aversion lies in missed opportunities. Your obsession to avoid losses may forgo higher-return investments that could significantly grow wealth over time.
In the context of inflation and changing market conditions, sticking to overly cautious investments can erode purchasing power—further amplifying the real cost of lost opportunities.
4. Herd mentality
You might be inclined to follow the crowd, driven by the emotional comfort of conforming. The fear of missing out or the fear of being wrong often drives herd behavior, even if it goes against your analysis.
During a market rally, you might buy into stocks simply because everyone else is doing so despite lacking any solid analysis of the fundamentals. This can lead to overvaluation as prices may be driven more by hype than by a company’s true financial performance or future prospects.
The result? You could find yourself holding overinflated assets that are highly susceptible to a sharp correction once the bubble bursts.
5. Anchoring bias
Anchoring bias is relying too heavily on an initial piece of information (the “anchor”) when making decisions. This tendency can make you overly attached to a particular price or past experience, resulting in irrational choices.
When trading with anchoring bias, you might refuse to sell a stock until it reaches a previous high—even if current market conditions suggest it’s unlikely. Ultimately, this kind of bias can reduce overall portfolio performance.
6. Recency bias
With recency bias, you might place more importance on recent events while ignoring long-term goals. It can lead to irrational expectations about future market movements based solely on recent performance.
One of the most significant dangers of recency bias is that it undermines the principles of long-term investing. Again, you might assume a stock that has performed well in recent weeks will continue to do so indefinitely without considering the broader market context, so you fall into the trap of buying high and selling low.
7. Familiarity bias
Familiarity bias is a preference for the familiar. Here, you might stick to local assets such as domestic companies or industries you have experience in. Unfortunately, reluctance to take advantage of international opportunities can limit diversification and exacerbate unnecessary risks.
How to Avoid Behavioral Biases in Investing
Understanding behavioral biases is only half the battle—learning how to mitigate them is just as important. By recognizing your biases and taking proactive steps, you can make more logical decisions and improve your investment outcomes. Here are some strategies to help you avoid common behavioral biases.
Educate yourself on common biases
The first step to overcoming behavioral biases is education. By learning about the biases that affect investors, you can become more aware of how they might influence your decision-making.
Reading books on behavioral finance or taking online courses can help you identify when overconfidence or loss aversion affects your choices.
Do your research
Thorough research is a must before making any investment decisions, as relying solely on popular opinions or headlines can lead to biased conclusions.
Instead of mindlessly following market trends, gather information from multiple reputable sources and analyze the data.
Thoughtfully evaluate the information you encounter
Assess the information you receive by obtaining perspectives from multiple sources, and objectively evaluate your abilities without letting emotions or biases take over.
When reading a market prediction, consider the credibility of the source and compare it with other viewpoints to get a balanced perspective.
Stick with your objectives
After defining your financial goals, make a resolve to stick to them. Remembering your long-term objectives can help you avoid making impulsive decisions driven by market noise.
If your goal is long-term growth, avoid selling an asset during short-term price fluctuations.
Consult a financial advisor
Asking the opinion of a financial advisor can help you make more informed decisions. When you delegate the management of your investments to an independent advisor, you can mitigate the risk of making costly mistakes.
A financial advisor can provide a holistic, personalized approach to investment management. If you’re looking for expert guidance, consider working with a Certified Financial Planner® in Utah. Tencap can ensure your financial blueprint aligns with your overall goals, from investment planning to tax strategy and retirement planning.
Invest with Certainty
Behavioral biases can significantly impact your investment decisions, leading to suboptimal financial outcomes. By educating yourself, thoughtfully evaluating information, and sticking to your objectives, you can mitigate these biases and make better investment choices.
Likewise, you can benefit from having an impartial expert on your side to provide unbiased guidance and help you navigate complex financial decisions. Learn more about how Tencap Wealth Coaching can support your journey.
For more insight into how professional advisory services can elevate your financial strategy, check out 7 Reasons Why Our Advisory Services Are Worth the Fee.
Hi I am Joe
