Updated October 2018
A sound investment philosophy is important, however, increasingly important is your behavior about money. After all, it’s the actions and decisions you make with your money that determine your financial success.
In the world of finance, behavioral finance is a field of study that combines psychological theory with finance and economics. It aims to understand why investors act the way they do. Behavioral finance shows that investors’ choices can often be explained by behavioral biases, or traps, that can sometimes lead to bad decisions. Knowing what these behavioral biases are can help you overcome them in your own financial journey.
As asset management has become more commoditized, the role of a financial advisor has evolved. Now, investors should expect more from their financial advisor than just picking investments. Today, financial advisors can work with clients to fully understand their finances, including any biases.
As author and NY Times columnist Carl Richards says, “An advisor's job is to look you in the eye, shake their head, and walk you back from the ledge”.
Below are six behavioral biases with tips on how to combat each of them:
Sometimes, investors choose to invest in individual stocks of companies that are right in their hometown. The comfort and familiarity of a business down the street and a loyalty to support a business that employs so many friends and family can lead to an inaccurate assumption that it is a wise financial decision. In many cases, it is not.
For example, if you live in the Southern Tier of NY, odds are you own shares of Corning Inc. (GLW). I have worked with numerous locals, who were both Corning employees and non-employees. Unfortunately, some are biased in thinking Corning’s stock is consistently “headed higher.” The truth ist, Corning is a very good company but historically a poorly performing stock. It is very difficult to separate these two.
TIP: Don’t hold more than 10% of your investments in any one stock, even if it drives the economy of your hometown.
I saw this every time I took my kids to redeem a gift card at Toy’s R Us. My children were completely overwhelmed when faced with choosing between Pokemon, Shopkins, Legos, and the thousands of other toys on display.
I see similar behavior when it comes to clients picking mutual funds in their retirement account. I ask clients why they chose a particular fund. Most of the time, having choices is a good thing. However, an abundance of choices without guidance can lead to information overload. People end up picking random funds with no real strategy behind their choice.
TIP: Have an investment strategy! Do your research and know what you are looking for so choosing the appropriate funds is less overwhelming.
Herding or Trend Chasing
You see the disclaimer everywhere in the investment world, “Past performance is not an indicator of future returns.” Yet, performance track records are heavily marketed as the main reason to pick a fund.
When patterns are recognized, it can be tempting to believe in their validity. What happens is when investors find a pattern, they act on it. However, that pattern is already “priced in.” When a stock has “priced in” it means that all the information investors already know has been acted upon, causing the average investor to commonly buy high and sell low.
Tip: If your cousin Larry is giving you a stock tip, chances are it is way too late to jump on the bandwagon.
Regret aversion is when people avoid feeling pain. It can cause financial paralysis or inaction. My favorite example of this is sitting in too much cash. If you lack investment knowledge or confidence, keeping your savings in cash is an easy way to protect against the regret of market loss. Unfortunately, holding too much cash can expose you to inflation and reduce long-term purchasing power.
Not making a decision because of fear or regret can be just as dangerous and damaging to your financial future than making a bad investment choice.
Tip: If you find that you are afraid to make a financial misstep that is preventing you from investing your money, it may be time to hire a financial advisor to help you. The greater your assets, the greater the potential consequences for making a bad financial decision. A financial advisor can help you understand what next step is right for you.
Availability is when you can wind up overstating the probability of recent events because it is fresh.
For example, investor confidence is high right now because the economy has been doing so well. This confidence can lead to a bias that the market always goes up. However, no one should forget that the market will also come down, as is the cyclical nature of the stock market.
Lately, I have been having conversations with clients reminding them that markets do actually go down since it has been over nine years since we have seen a significant drop in performance.
Tip: If you find yourself thinking in absolutes like this, pause before making further financial decisions based on this assumption. It is dangerous to assume the market will ever behave a certain way. Remember, no one can see into the future!
This most current market run up has led some to feel overconfident in their investing skills. Investing is quite easy when markets only go up. And when you are making money and everything is good, it can lead to dangerous financial decisions. Overconfidence can cause you to assume too much risk in your portfolio.
Tip: No matter how the market is performing today, don’t be lulled into a state of overconfidence and complacency. Maintain a diversified portfolio based on your risk tolerance and risk capacity. That way, when the market surprises you (and it will), your long-term financial well-being is preserved.
How we think about finances affects how we act about money. The examples of the common behavior biases I shared in this article are examples of how dangerous these biases can be when it comes to making investment decisions. For this reason, having an objective third party who is obligated to helping manage your finances in your best interest can be a tremendous benefit to helping you reach your financial goals. Remember, if you are feeling like you are getting tripped up by some of your own biases when it comes to money, you don’t have to go it alone.