As far as technology has advanced, it’s far too easy to stand in your own way when it comes to making good financial decisions. Whether you realize it or not, your inherent biases could be curbing your portfolio’s growth potential.
The good news? Even though we’re all human, there are things you can do to separate your biases from your decision-making. Below are five common biases and a few easy tips for overcoming them.
What Is a Cognitive Bias?
The truth is that everyone has cognitive biases that hold them back—yes, everyone.
A cognitive bias refers to the errors made when personal beliefs impact decision-making. Cognitive biases color your experience and perspective toward the people, places, and events around you and are your brain’s attempt to simplify complex information processing.
These unconscious behavior-drivers impact your judgment and decision-making processes.
Cognitive biases can impact all areas of your life, including your investment strategy. To determine what biases could be influencing your portfolio, consider these five common bias types— including what makes each one so critical.
5 Common Biases That Impact Investing
Exploring and identifying your potential cognitive biases is the first step in correcting and overcoming them. It also lays the groundwork for unlearning negative financial habits and instilling healthy ones.
#1: Overconfidence Bias
An overconfidence bias creates a false sense of skill, talent, or self-belief. Maybe you’ve heard someone say they paint like Picasso or invest better than Buffet—while aspirational, overconfidence bias likely shapes these thoughts.
In terms of investments, overconfidence bias can take the form of wishful thinking or timing the markets. These investors may underestimate how long it’ll take for an investment to pay off. Or, they may be sure in their ability to time, pick, and invest in the latest hot stock.
Why Is Overconfidence Bias Dangerous?
While confidence and money are good companions, overconfidence can compound into a more significant problem. This mindset may lead investors to create an abnormally high-risk portfolio and disengage from their long-term goals.
It’s important to hear and welcome other perspectives and look at data from an objective lens. You want to create a portfolio with the proper risk tolerance for your needs—not a portfolio built on intuition alone.
#2: Confirmation Bias
People naturally tend to favor information that confirms their current beliefs. It’s human nature to actively search for, interpret, and retain information that matches your preconceived notions—people like to confirm what they already know.
Doing so can lead to biased research, only seeking out information you want to find and avoiding sources that contradict it. Similarly, biased recall refers to the ability to only remember events that align with your beliefs.
Why Is It Dangerous?
Only looking at information that already aligns with your beliefs can lead to flawed decision-making and missed opportunities. Confirmation bias can also lead to investors pouring too much money into a particular market sector or company.
It’s essential to be as comprehensive and objective as possible. You don’t want to be caught in a one-sided, opinion-driven financial plan. You want to make financial decisions with complete information, not just information you want to be true.
#3: Loss Aversion
If you are more focused on the potential for losses than the potential for gains, loss aversion may drive some of your investment decisions.
This is a common bias, as losing money can trigger an intense emotional response. For example, loss-averse investors would rather avoid losing $2,000 than earn $3,000. These types of investors may hold on to a lot of cash or liquid assets, and they tend to invest in only the most conservative options (such as a certificate of deposit (CD) or money market account.
Why Is It Dangerous?
While it’s important to be comfortable in your financial standings, being too loss-averse leaves valuable opportunities on the table, you can’t reach your goals if you’re only focused on not failing. You’ll likely put yourself further behind on significant goals like a career change or making work optional.
Even further, you may be less inclined to sell a declining investment because you may not want to acknowledge it isn’t working and fear that selling would have even worse consequences.
#4: Hindsight Bias
As the saying goes, Hindsight is 20/20.
Hindsight allows you to reflect on your triumphs and losses. But a hindsight bias can be troublesome for investors. It’s the idea that investors can accurately predict market outcomes. If the prediction comes to fruition, some may claim they “knew it all along.”
The market crash of 2008 is an excellent example of hindsight bias. While this crash took most of the country by surprise, some swear they knew it would happen.
Why Is It Dangerous?
When investors believe they can predict the market’s future, there becomes a real potential for poor decision-making. Experience and education go by the wayside, as they believe the future has already been foreseen. But the reality is, unpredictable outcomes will occur no matter how skilled an investor may be.
#5: “Bandwagon” Bias
You’ve heard the saying “jumping on the bandwagon.” Well, there’s a bias for that. When you follow what other investors do (maybe because you’re a friend or a fan) without conducting your due diligence, you’ve succumbed to a bandwagon bias.
This can be a common issue amongst groups of investors making collective decisions. Some will follow along with the loudest voice in the room, despite their personal objections or concerns.
Why Is It Dangerous?
With bandwagon bias, your primary influencer is emotion rather than independent analysis. Just because Warren Buffet or your next-door neighbor buys a particular investment, that doesn’t mean it’s right for you. More importantly, it doesn’t mean it’ll help you reach your unique financial goals.
How to Overcome Biases & Make Better Investment Decisions
By now, you’ve likely accomplished the first step in overcoming your biases— identifying and acknowledging them. Understanding what biases may be clouding your investment decisions gives you the power to overcome them.
What you need to do next is create a system that helps take the emotion out of your investment decision-making process. This could include researching from credible sources, fact-checking in multiple places, and working with a financial professional who can offer unbiased assistance.
Brightview Financial Solutions is built on the ability to help tech professionals like you establish and manage a tailored portfolio. That includes discussing, identifying, and overcoming personal biases together.
If this is something you’re interested in addressing, please don’t hesitate to reach out. I’m happy to chat about your specific concerns and what checks and balances we may put in place.
Remember, investing is a marathon, not a sprint. Together we’ll take a long-term view of your financial goals once we’ve put a good plan in place.