Your Behavior will Impact your Financial Future
We make thousands of choices throughout the day which have a wide range of outcomes on our lives, some muted but others extraordinarily profound. Some of these decisions are very logical, while others are clearly driven by our emotions.
Understanding some of our common behaviors can help us make better choices and potentially be a better investors.
For example, do you consider yourself a better-than-average driver?
Chances are, you answered “yes”, and you would not be alone. According to AAA, nearly three-quarters of people think they are better-than-average drivers. Obviously this is mathematically impossible and is fantastic example of overconfidence (more on this below).
Behavioral biases can cloud our judgment and drive us to make irrational decisions. This is especially true when it comes to investing.
The good news is that recent studies and evidence suggests that we can learn how to overcome these biases and improve our decision-making. But first we must understand how they work. For the purpose of this article, we will take a look at three of the most common behavioral biases that can impair our investment decisions.
Bias One: Anchoring
You own a stock that was recently selling for $100 per share but has since dropped to $60 because of a shift in the companies fundamentals. But, you are convinced that the right value for that stock is $100. As a result, you may hold onto your stock waiting for a rebound that may never come.
You’ve fallen victim to anchoring, the behavior when your emotional attachment to the past value of an investment keeps you from recognizing its true, present value.
When looking at your investments, ask yourself: are you holding on to a position based on the current reality or your past feelings about the stock? Are you behaving like a rational investor or speculator? Weigh the merits of keeping an investment based on current information and whether it’s still a good fit for your overall financial plan.
Recency bias can lead to putting too much emphasis on the latest, most recent information while ignoring other important data. For example, say stocks begin to climb and that uptick inspires a surge in buying. As more investors pile on, prices climb even higher, surpassing historically expensive levels. The market is now overpriced but the retail investor empowered by recency bias and FOMO continue to buy. A bubble is now festering and forming. Bubbles like these can pop and falling prices can potentially leave investors with heavy losses.
You can avoid recency bias by taking a long-term approach to investing. Strategies such as dollar-cost averaging, when you make a series of regular investments regardless of the market’s ups and downs, can help erase the temptation to chase returns or panic when prices fall.
Bias Three: Overconfidence
Back to overconfidence.
We all know that confidence is useful and, in many cases, necessary. Starting a new business takes confidence. Grit is rooted in confidence. Investing a chunk of your income in the stock market takes confidence. And it’s confidence that allows you to keep risks in perspective and sit tight in a turbulent market rather than rushing to sell your assets and locking in losses.
But overconfidence can be dangerous. It can lead you to believe that you know better than experts, that you can predict market movements successfully (spoiler: you can’t), or that you can spot investment opportunities others have missed (in my humble opinion, many “experts” and TV pundits suffer from chronic overconfidence). Worst of all, it can lead to emotional decisions in response to market moves, such as buying when prices are high and selling when prices are low.
Combat a tendency toward overconfidence by basing investment decisions not on emotion, but on careful research and thorough advice and guidance. Once you have made a decision, stick with it and avoid the temptation to try to outsmart the market by jumping in and out of investments.
Recognizing these behavioral biases and how they can impact your finances is critical. Working with a professional advisor, who is a CFP® and, therefore a fiduciary, can help mitigate the potential negative results of poor, emotional decisions. A portfolio deeply rooted in a long-term financial plan can help place short-term emotions in perspective. Finally, understanding the risk and volatility embedded in a portfolio can help you remain calm during irrational times.