Behavioral biases can lead to costly investment mistakes
The field of behavioral finance focuses on the emotional and cognitive aspects of investing. In recent decades, well-known economists have advanced the theory that investors’ decisions can be driven by human emotions such as greed and fear, which helps explain why the stock market sometimes fluctuates erratically.
It can be difficult to act rationally when your financial future is at stake, especially when unexpected events upset the markets. But understanding certain aspects of human nature, and your own vulnerabilities, might help you stay levelheaded in the heat of the moment.
Every investment decision should take your financial goals, time horizon and risk tolerance into account. It’s critical to slow down and consider all relevant factors and possible outcomes. Here are five behavioral biases or blind spots that may lead to regrettable investment decisions.
Herd mentality. Many people can be convinced by their peers to follow trends, even if it›s not in their own best interests. Chasing returns and following the herd into “hot” investments that are overvalued, or fleeing the stock market after it drops, could harm your long-term portfolio returns.
Availability bias. People tend to base their judgments on information that immediately comes to mind. This could cause them to miscalculate risks or expected returns. In the same way that watching a movie about sharks can make it seem more dangerous to swim in the ocean, a recent news story can shape how you perceive the quality of an investment opportunity.
Confirmation bias. People also have a tendency to search out and remember information that confirms, rather than challenges, their current beliefs. If you have a good feeling about a certain investment, you may be more likely to ignore critical facts and focus on data that supports your opinion.
Loss aversion. People feel the pain on losses much more than they enjoy gains. Since it feels bad to experience a financial loss, when your portfolio is losing value you might want to sell everything to stop the pain even though your portfolio might be appropriate based on your goals and timelines. An intense fear of losing money may even be paralyzing.
Anchoring effect. When making decisions, people often depend heavily on the first information they receive, then adjust from that starting point based on new data. For investors, this translates into placing too much emphasis on an initial value or on recent market performance. Investors who were «anchored» to the financial crisis may still be fearful of the stock market, even after years of strong returns. Another investor who has only experienced years of gains might be inclined to take on too much risk.
In these unprecedented times, uncertainty about the pandemic’s impact on the global economy and markets remains. A good financial plan is designed to help manage through uncertain times like these. It should have a long-term perspective with a thoughtfully crafted investing strategy to help you avoid expensive, emotion-driven mistakes. It may be helpful to consult with an objective financial professional, who can help you detect any biases that may be clouding your judgment.
Kristin Guibord, MBA, AIF®
Senior Investment Manager
1000 Elm Street, 4th Floor
Manchester, NH 03101