This article originally appeared in Aldrich Community, a client experience offering from Aldrich Wealth.
In the world of investing and personal finance, numbers and data often take center stage, overshadowing the crucial role psychology plays in decision making. That said, we cannot ignore the impact that our emotions and cognitive biases have on our financial outcomes. Recently, a client shared that their teenager, influenced by excitement and fear of missing out, had achieved impressive returns by investing in stocks like Zoom and Peloton during the pandemic. It was fascinating to witness how a young investor armed with a Robinhood account could outperform even the most seasoned hedge fund manager on Wall Street. Such unparalleled success, however short lived, is rarely seen in other industries; a teenager cannot perform brain surgery with the same precision as a licensed neurosurgeon nor match the prowess of LeBron James on the basketball court. So, what sets investing apart? The answer lies in the interplay of emotions like fear, greed, and occasional luck, which have a profound influence on investment outcomes, sometimes for the better but more often for the worse.
Understanding the intricate relationship between our minds and money is crucial for achieving long-term financial goals. By recognizing and mitigating common cognitive biases, we can make better-informed choices and improve our financial well-being over the long term. In this article, we’ll shed light on five common biases, share examples, and provide valuable tips to help avoid these strong prejudices when making personal financial decisions.
Definition: The tendency to overweight new information or events without considering the objective probabilities of those events recurring over the long run.
Example: Investors often believe they can accurately predict short-term market movements based on recent trends. This likely leads to selling stocks after a market decline or buying stocks after a market rally.
Definition: The tendency to rely heavily on initial information presented when making subsequent judgments or decisions.
Example: An investor buys a stock at $100 per share. When the price drops to $70, they may be reluctant to sell because they are anchored to the initial price of $100 regardless of new information about the company or industry.
Definition: The tendency to mentally compartmentalize money into separate “accounts” based on various criteria such as the source of funds or the intended purpose.
Example: Many investors divide their assets between safe portfolios and speculative ones on the premise that they can prevent the negative returns of speculative investments from impacting the total portfolio.
Definition: The tendency to follow the actions or decisions of a larger group, often disregarding one’s own judgment or analysis. This behavior is driven by the desire to conform, seek validation, or avoid the fear of missing out.
Example: Periods of speculative mania often lead to rapid rises in various assets such as technology stocks in the late 90’s, real estate in the mid-2000s, and most recently, cryptocurrencies and meme stocks.
Definition: The tendency to inflate one’s own abilities, knowledge, or decision-making skills, overestimating accuracy, underestimating risks, and believing they have more control or information than they actually do.
Example: Overconfident investors may believe they have identified a few “sure win” investments and concentrate their portfolio in a limited number of assets, lacking diversification.
Avoiding Recency Bias
As mentioned above, we see recency bias often as it relates to how the stock market has been performing lately. Individuals may incorrectly believe that recent events will occur again soon because they have a clear memory of them.
When it comes to investing, it’s important to have a predetermined investment strategy and stick with it regardless of short-term trends, news, or volatility in the market. Make sure to conduct thorough research, maintain a diversified portfolio, consider historical trends, and adhere to a long-term investment strategy based on sound financial principles rather than short-term fluctuations.
Anchoring manifests as an inclination to fixate on a specific reference point such as the initial purchase price of an investment or a random numerical target. It also speaks to the tendency of people to use their own experiences to shape future judgment. This irrational bias can cause investors to hold onto investments even if the fundamentals of the investment have diminished significantly.
To mitigate anchoring, it helps to start by becoming aware of its influence, then take steps to overcome it. Try and think critically about what measures to use when evaluating an investment opportunity and constantly update your estimates and valuations based on new information and market conditions. Your advisor can help you view investments objectively and identify any current anchors you may have.
Avoiding Mental Accounting
Individuals may be more prone to spend windfalls on discretionary items based on subjective criteria such as where the money came from, rather than allocating the windfall towards long-term goals or paying off debt. We see individuals spending bonuses without the same caution as their hard-earned income. Similarly, we often see folks invest their 401(k) much more conservatively than a separate account designated as their “fun money”.
It is important to try and treat money as interchangeable no matter where it comes from. Be deliberate with your money and think critically about your spending habits. Consider all income, expenses, assets, and liabilities collectively to make more rational and effective choices regarding your money.
Avoiding Herd Behavior
This is a very common tendency to mimic actions, whether rational or not, of a larger group. Largely influenced by emotion and instincts rather than by independent analysis, herd behavior most commonly leads to asset bubbles. Individuals see the rapid rise in asset prices and jump on the bandwagon without conducting proper due diligence, causing the price to go up even more although the underlying fundamentals might not warrant the influx of investors.
Try consulting with your trusted advisor, doing your homework, and avoiding rushed decisions. Just because everyone is making a certain investment does not necessarily mean the strategy is correct. Make sure to separate optimism from the fundamentals that drive performance and seek advice from trusted sources.
The name speaks for itself, as this bias leads people to overestimate their abilities and understanding of a topic at hand, giving themselves an illusion of control. While confidence is considered a strength in many situations, in investing it tends to more frequently be a weakness. Overconfidence might lead investors towards excessive trading, neglecting proper risk management and financial planning, and a disregard for diversification when concentrating a high percentage of their net worth on a single type of asset that they believe they know very well.
To mitigate the impact of overconfidence, individuals should regularly assess their own limitations and try and seek feedback from knowledgeable and objective sources. Try and become aware of your own biases towards overconfidence, stay informed, and be open to various perspectives. Consider all the possible outcomes of an investment including if it is unsuccessful and what the impact would be on your overall wealth.
In short, biases frequently lead to irrational choices that negatively impact our long-term wealth. Recognizing these biases is the first step to making more informed financial choices.