The phrase “know thyself” has been around for centuries because it still rings true. Self-knowledge is a goal in every philosophy and religion in history, vital to every area of life, and finance is no exception. Our instinct, our gut, leads us in a certain direction if we are paying attention. We either sit on our hands or take action and fret about outcomes. Behavioral bias in finance can lead you down a perilous path, but knowing ourselves can help us navigate around the biases that could get in the way of achieving our goals.
Behavioral Bias—how did we get here?
As humans we love our shortcuts, from how to get to the grocery store to how to get those groceries loaded in the car. Thinking and acting efficiently is an impulse we are born with, and it sharpens over time.
Most of the time, these shortcuts work well for us. They help us act quickly under physical threat, and keep our heads above the rushing current of modern life.
Do Your Biases Affect Your Bottom Line?
Yet these same instincts, so deeply ingrained we are rarely consciously aware of them, can be disastrous when it comes to investing. Our fight-or-flight reflex can cause us to act too quickly or paralyze us altogether. It can mire us in what neurologist and financial analyst William J. Bernstein, MD, PhD labelled a “petri dish of financially pathologic behavior.”
So what kind of behavior is he talking about?
- Counterproductive trading – i.e., racking up trading expenses, buying high and selling low.
- Excessive risk-taking – i.e., rejecting the security of global diversification, and following recent winners and losers.
- Favoring emotions over evidence – i.e., choosing against researched results in favor of the feelings of the moment.
What Can You Do About It?
In this series, “The ABCs of Behavioral Biases,” we’ll learn how to spot pitfalls and potential traps on your investing journey. Cultivating awareness can help you see biases at work so you have options to consider before taking any action, and help curb the damage before it’s done.
How can you get a handle on something you are not even aware of? We recommend getting your bearings by considering these three initial coordinates that can help you cultivate awareness.
1. Anchor your investing in a solid plan
Your journey is often only as good as your map. By planning carefully and using your goals and risk-tolerance as guides, you’ll be better able to see past your behavioral biases further down the road towards your goals.
2. Increase your understanding
Good reading can help your awareness of your financial instincts. Here’s a library we’d suggest.
- Mastering Behavior Biases, Kyle Walters
- Predictably Irrational, Dan Ariely
- Why Smart People Make Big Money Mistakes, Gary Belsky, Thomas Gilovich
- The Undoing Project, Michael Lewis
- Nudge, Richard Thaler, Cass Sunstein
- Your Money & Your Brain, Jason Zweig
3. Don’t go it alone!
Seeing your own biases is like trying to look at the end of your own nose – you can never quite see it. Seek out an advisor who understands behavioral finance, and your financial biases, that can act as your guide to help bring what you may not see into your field of vision.
With this series, we hope to provide you with important tools to help you recognize and protect yourself against your own behavioral biases. “Knowing is half the battle,” as the saying goes, and though none of us will ever be completely free of biases, awareness will help give you an edge.
In our next article, we’ll start our ABC series on the most common biases.