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For many of us, money is a very personal thing. How you feel about money has a direct impact on how you earn, spend, save, or invest it. And whether you recognize it or not, your history and relationship with money—your employment security, investing experience, even how your parents discussed financial matters—can influence your approach to investing.
Behavioral finance is the study of psychological factors that affect the investment decisions you make. These decisions are impacted by biases that alter your view of how things work based on how you feel or see things. It’s natural to have biases, especially with money, but when they get in the way of your ability to make sound investment choices, they can lead to bad decision making.
In his book The Psychology of Money, author Morgan Housel says, “Your personal experiences with money make up maybe 0.00000001% of what’s happened in the world, but maybe 80% of how you think the world works.”
Only when you recognize your biases can you learn how to overcome them…to make better, more rational investment decisions.
What are investing biases?
The choices we make as investors are subjected to two primary types of bias:
Cognitive bias
A cognitive bias describes how the decisions you make depend on your view of the world. Those perceptions may or may not be accurate. For example, if you are confident in your job security, you may not see the need to have an emergency savings fund. If you work in a certain industry, you may want to invest your money in that sector because you think you understand it. Or, if you think a certain type of investment holds opportunity, you’ll only read articles that support that position.
Emotional bias
An emotional bias describes how the decisions you make depend on how you feel. These are deep-seated opinions formed by many factors, including where you grew up or how you were raised. For example, if you are cautious by nature, you may make investment decisions that are solely based on avoiding loss. Or, if you inherited investments from a beloved family member, you may be reluctant to change the portfolio mix because of your emotional attachment to the source of the funds.
5 Biases affecting your investment decisions
Here are some common ways that people let their emotions and their views of the world impact the money decisions they make.
1. Recency bias
If what you see on the news influences the decisions you make with your investments, it can cause you to make hasty decisions or chase after trends. For example, if you’re swayed by the fact that everyone is talking about cryptocurrency, you may want to jump in to avoid FOMO (fear of missing out), even though crypto may not be the right choice for you. People with recency bias tend to chase the market or follow the herd instead of making planned strategic decisions.
2. Loss aversion
Regret is a powerful emotion. While risky investing has its drawbacks, the opposite can also be problematic since avoiding risk can also cause you to lose money. For example, by ‘sitting tight’ in hopes that a losing investment will recover to make up the loss, you’ve lost the opportunity to move that money to a positive investment position.
3. Familiarity/Home bias
It’s natural to want to invest in things you understand, but your decision to stick only to what you know may hurt you. If you want to hold on to stock from an old employer, for example, you may end up with a portfolio that is too concentrated in one security. On the flip side, your unwillingness to invest in sectors you’re not familiar with can leave your portfolio unbalanced.
4. Framing
First impressions and preconceived notions are real things. It’s natural to want to see things in a way that confirms what you think you already know but recognize that the way in which something is presented will ultimately frame your opinion. A financial professional can help you see things more clearly, without framing bias.
5. Mental accounting
Where your money came from can impact the investment decisions you make. If you’re investing funds you inherited, you may take more risks than if you’re investing money that you worked hard to earn yourself. If the money you set aside has a specific purpose—saving for a house or college, for example—you may be less willing to make an investment that could lose value over time.
Overcoming your biases: The Four "R"s
Money is a personal, emotional thing. It’s natural to have investment biases, but here are simple steps you can take to overcome them.
1. Recognize
First, make yourself aware of the fact that your views or feelings may be influencing your investment decisions. Ask yourself if your opinions are rational or being driven by emotions; if your decisions are influenced by perceptions or actual truths. When in doubt, use the old trick of listing the pros and cons of an investment decision to help separate feelings from facts.
2. Reflect
Take time to think about your decisions. Do they align with your goals? Do they match your values? Strategic investing shouldn’t be a race to the finish line. Give yourself breathing room to make good decisions.
3. Reframe
Time gives you the ability to look at things differently and remove biases from the equation. This is a great time to learn about both sides of the issue. A good investment professional can add value at this stage.
4. Respond
Once you’ve had a chance to evaluate a topic and remove bias from the criteria, you’re ready to move ahead. And you can do so with confidence, knowing that you’re doing so with clear, less biased goals and objectives.
