When it comes to money and investing, most people immediately think about numbers, math, and research.
However, the reality is that money and investing can sometimes be even more impacted by our emotions, behaviors, and psychology.
Enter the world of “Behavioral Finance”!
What Is Behavioral Finance?
Behavioral finance is the study of the effects of psychology on investors and financial markets. More specifically, it focuses on explaining why investors often appear to lack self-control, act against their own best interest, and make decisions based on personal biases (instead of facts).
We know that the definition is a lot but in simple terms, behavioral finance aims to explain why humans and markets do not act in rational ways.
Because we are emotional creatures that deal with fear, greed, bad days, and good days, it makes sense that every decision that we make around money is not perfect.
The good thing with all of this is that by understanding behavioral finance and more specifically some of the common behavioral biases that we all fall prey to, we can grow this muscle to make smarter money decisions.
The Six Most Common Behavioral Biases To Know
While there is an ever-growing list of behavioral biases that investors demonstrate, we thought it would be helpful to narrow our conversation to the six most common:
Recency Bias: Being easily influenced by recent news or a recent experience.
Loss Aversion Bias: Playing it safe or accepting less risk than you can tolerate.
Confirmation Bias: Seeking information that reinforces your perception or viewpoints.
Familiarity or Home Country Bias: Preferring to invest in familiar or U.S. domiciled companies.
Anchoring Bias: Focusing on a specific reference point when making investment decisions.
Herding Mentality: The tendency to follow and copy what other investors are doing.
As you read through the list above, take a step back and think about how you may have fallen prey to any one of these biases.
For recency bias, if we think about the fear during the COVID-19 sharp decline and how that impacted investor behavior, there were a lot of investors who missed out on the quick recovery. Investing is emotional and it would have been very hard to “forget” about the sharp decline in the markets.
For loss aversion, it is all about being more impacted by losing $1 vs. gaining $1. It hurts more to lose $1 than the pleasure associated with gaining $1. This doesn’t make sense! Extrapolate that to your retirement portfolio and you can quickly start to think how investors can become irrational when playing it safe hurts their long-term outcomes.
For confirmation bias, this could involve an investor having a plan to invest his/her money into a specific strategy (stock, fund, etc.) and then seeking out friends, news outlets, research reports, etc. that align with his/her thinking. Overcoming this bias can be somewhat done by “tuning out the media”.
Familiarity or Home Country Bias is a very common one in the U.S., where investors tend to feel more comfortable or safe investing in companies in the U.S. This results in having much less international exposure that would make sense given the total weight of international within a truly global portfolio.
Anchoring is another behavioral bias that can really impact investor behavior. With the Anchoring Bias, an example would be an investor holding on to the price of a specific stock and using that point in time to make a decision. In this case, if the stock continues to go up, they may miss out on buying the holding at the lowest price.
With the Herding Mentality, this can be seen when an investor sees a trend or hears about a hot stock. By the time that they follow the trend or buy the hot stock, it is already too late. In this case, they were late to the boat and probably paid too much.
How To Overcome Behavioral Biases
In the descriptions above on the six common behavioral biases, we only scratched the surface of how investors, savers, and retirees are impacted.
The truth is that behavioral biases and our emotions are real when it comes to investing, saving, and planning for retirement.
The key is to find ways to overcome these behavioral biases and that is not an easy task. We are wired to be emotional, but that does not mean that we cannot improve.
Here are three simple tips to think about to help overcome our behavioral biases:
Always think about the long-term
Put everything in perspective of your personal goals
Automate, automate, automate
These simple tips seem straightforward, but when markets are volatile or if you are stressed, it is not always easy to act in a rational manner. By thinking about these three tips and putting things in place, you can be one step ahead of your behavioral biases.
The Value Of Working With A Financial Planner
Financial planning is not just about managing investment portfolios. More importantly, it is about having someone you trust to guide you when the unexpected occurs and to make sure your family has a trusted resource to rely on.
At Abel Financial Management, we are local, family-oriented, and truly independent financial planners with a mission to help you make smart decisions with your money. If you or someone you know faces decisions like these, we invite you to have a conversation with us.