When it comes to money, humans are not exactly rational. In fact, there are six cognitive biases related to money that can be harmful to investors. These detrimental biases can derail the ability to make the best possible decisions about how to build wealth. Oftentimes, clients do not realize their decisions are being negatively affected by these six biases:
Clients affected by this bias often overestimate the confidence level and the accuracy of their own judgment as greater than the objective accuracy of those judgments. In other words, the subjective estimation of our own accuracy and reliability is greater than it objectively is. This bias can result in an investor that has an unrealistically positive view of performance and results. To overcome relying on our own confidence, rather than data, it is important that we ask ourselves if our judgement is based upon our own level of knowledge or if we have applied due diligence in research and fact gathering. (For more, see: How to Avoid Emotional Investing.)
We often make assumptions during the decision-making process based upon patterns and outcomes we’ve previously observed. For example, when we select funds to invest in, we often select those that are the most familiar or ones we recognize. This bias can result in an investor that is immobilized, despite the possible benefits that can come from diversification. To put this bias to rest, we must understand our need to seek out patterns where there are none and commit to remaining open minded about things we may not have heard of before.
When we are under stress or are being hit by too much information, we naturally adopt coping mechanisms. One of these mechanisms is to over simplify the problem. The problem with this tactic is the less knowledge and understanding we have about our investments, the less we cope. This bias can result in an investor that is readily paralyzed at the prospect of too many choices. To control our innate desire to over-simplify issues, we must tap into our patience and affirm to ourselves that we are not simply taking the easy way out rather than doing the work necessary to reap the benefits.
Once an option presents itself, we sometimes anchor ourselves to this original piece of information, failing to sufficiently adjust our mindset or consider the realm of other possibilities. This means we selectively filter out information, preferring to focus on data that support our views. This bias can result in an investor that may only look at options which support their original view, rather than seek out information that informs other views. To overcome this bias, it is important to recognize that historical data can provide us with great insight into current data, but we must ensure we do not automatically adopt historical conclusions. (For more, see: Understanding Investor Behavior.)
This bias takes place when rational people begin behaving irrationally by limiting judgement based upon what others are doing. We often look to others, including institutions, for affirmation and acceptance, allowing them to color our judgement. The same holds true as we gravitate to investments based upon what others are doing or what we’ve heard. To stop ourselves from selectively seeking out the opinions of others in our judgments, we should avoid listening to the “noise” and instead, seek out verifiable data. By considering the alternatives, we can fully vet our judgments and help ensure they are not based solely upon what the group is doing.
Our experiences with loss mean we rank it higher than other experiences. According to academic research paper, Advances in Prospect Theory: Cumulative Representation of Uncertainty, our past losses feel worse to us than our past gains feel good. Sometimes we make decisions based upon the fear of loss so as to avert its occurrence instead of considering the benefit of potential gain. Sometimes we go to illogical lengths to avoid the loss, which can negatively impact our desired outcome. To control our tendency to freeze, we should make sure our plans allow for wiggle room and recognize that statistically, the odds of both loss and gain are equal in strength.
By understanding these six biases we hold the key to safeguarding the negative impact they can have on our decision-making process. It's important to identify our innate tendencies toward irrational behaviors and draw up a plan to manage our biases. A good plan will simply mirror you. A great plan will guide you along every step of the way to help you meet and exceed your goals. (For more, see: Behavioral Bias: Cognitive Versus Emotional Bias in Investing.)