We’ve all been there. We didn’t think it through and made a poor decision with our money. Was it because of something you didn’t know in the moment, or maybe you received some poor advice? Or was it more innocent than that: Did you fall victim to a cognitive gaffe or an emotional bias?
Behavioral finance is an emerging field of study focusing on natural human errors and biases, and how they can impact our behavior as consumers, business owners, and even as investors. More often than not, that impact can be negative, or technically speaking, ‘irrational’.
It is widely known that personal financial success is greatly improved by recognizing and routinely reviewing one’s own capabilities, goals, and financial plan. But our industry is quickly coming to grasp with the importance of properly understanding the behavioral biases of our clients and helping mitigate our self-destructive behaviors.
A Variety of Cognitive Traps
Many of our irrational (aka. human) behaviors can often be attributed to specific behavioral biases. Be aware of common biases that impact the clarity of your decision-making. Examples include:
- Action Bias: The desire to take action, at any cost, in an effort to gain control over a situation.
- Overconfidence Bias: Starkly put, the tendency to overrate our own skills and abilities.
- Mental accounting: is the tendency to treat money, differently depending on where it came from or what we intend to do with it.
- Loss Aversion: The inclination to prefer avoiding a loss to realizing an equivalent gain (i.e., people would rather not lose $10 than gain $10).
- Present Bias: The idea that we are time-inconsistent, this bias causes people to place greater value on a reward today than they would on a reward in the future, typically to the detriment of our future selves.
- Recency Bias: Causes one to overemphasize recent events/results over historic ones.
- Herding Behavior: An investors’ tendency to track what other investors are doing, rather than their own analysis.
Certain people may be more prone to some over the other of these biases, and at times, broad economic and social situations can cause these biases to occur more frequently and on a larger scale, than usual. For example, the stress associated with the past election, dramatized news cycles, and the global pandemic are having detrimental effects on our psyche, causing some biases to become more prevalent and influence the way we behave.
What Can Investors Do?
Too often, we meet with clients who have mismatched financial strategies. By that, we explain their current investing strategy is not aligned with their risk tolerance and goals. Why does this occur? Experience tells us, there are three primary reasons:
- Infrequent and inaccurate assessments of their financial situation and goals.
- Mistaking what they feel, hear, or think for facts and knowledge (behavioral biases).
- Fundamental gaps of knowledge about specific financial areas such as market behavior, tax implications, and investment selection.
Typical mistakes include making investment decisions expecting the near future to be similar to the recent past; investing aggressively but disregarding your upcoming cash withdrawal needs (i.e., home down-payment or paying off credit cards); selecting the wrong type of IRA; and fanatically watching the markets. It’s also very common, and perhaps even typical, to rationalize disappointing past decisions.
Of course, it is helpful to recognize when financial behavioral biases have crept into your thinking. A good place to start is simply questioning why you believe what you believe. Know who you are, do a bit of self-examination. Looking at the biases list above, do you think you are vulnerable to any of these biases or cognitive errors?
As with most things, awareness is the first step toward correction. Consider past mistakes; what may have motivated your behavior when you made those errors? If you understand your own susceptibilities, you are much better prepared to catch yourself. If you have a financial plan in place already, there are less choices to make in real time. Fewer decisions mean fewer chances to make a mistake.
A financial plan can be a sense of comfort in rough markets. You can ride through a tough market if you know that you already mentally prepared and have properly planned for that situation.
When it comes to your financial success, working with a financial consultant puts a considerate and experienced individual in that place. We believe putting a qualified expert between your emotions and your money is one of the best moves you can make.
Please consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. The information in this article is not intended as legal or tax advice.