Your Wealth Journey Investment Insights: Mastering Behavior Biases

In our last installment, we talked about how one of the most difficult factors of evidence-based investing is overcoming our own human intuition. Intuition-based investing might lead to short-term success, but it’s not going to last.

When it comes to your financial journey, understanding your behavior and where it comes from is an essential step in moving toward your goals. Today, let’s think about six of the main offenders when it comes to our behavioral biases.

#1: Herd Mentality

“C’mon. Everyone is doing it.”

Yes, it’s the clichéd, “after school special” version of peer pressure, but it’s a very real struggle in the world of investing.

When we see the market moving a certain direction and decide to do the same, that’s herd mentality.

It might be a stampede toward a hot buy or it could be a mass exodus from some perceived risk. Either way, when everyone’s doing it, it’s hard to avoid the feeling that they know something you don’t.

Your plan says, “Keep moving,” but the herd has you second-guessing everything.

The problem is, the herd’s path leads to buying high and selling low. Before you or the herd can properly react, the market has been adjusted. Remember, it’s near impossible to beat the market on news.

#2 Recency

“Did you hear the latest?”

New news is so much more exciting than old news. When we hear the latest, we often find ourselves giving this new bit of information added weight, purely because it’s new.

For instance, we know that stocks have historically provided premium returns over bonds. And yet, whenever stocks dip, investors give in to their recency bias and head for the “safe harbor” of bonds.

Your evidence-based plan is founded on strong principles designed to hold up over a long period of time. Making changes based on the newest, shiniest ideas or news violates the foundation of those principles.

#3 Confirmation Bias

“See? I knew I was right.”

We have a tendency to favor evidence that goes with what we already believe, and gloss over anything that refutes it. We’ll linger on articles and news reports that seem to confirm our notions, but we tend to ignore those that challenge us to accept something different.

Confirmation bias is the reason “fake news” has been so prevalent lately. It confirms people’s preconceived notions.

It’s easy to see why this bias is so strong. Everyone wants to be right. The problem comes when that desire clouds our judgment so much that we ignore anything that proves us wrong.

Confirmation bias reinforces the importance of a rigorous, peer-reviewed approach when making investment decisions. Having a guide to point out when confirmation bias may be affecting you is immensely helpful in avoiding its pitfalls.

#4 Overconfidence

“I know my needs and how to meet them better than anyone.”

Confidence is great. It helps us achieve great feats, whether in our personal or professional lives.

Sometimes we become so confident in our ability that we fall into overconfidence – the belief that we’re better than we actually are. When overconfidence infects our investing decisions, we may start believing we can time the markets and get in and out at just the right time to make the most money and miss out on the downside.

When we start feeling this way, it’s important to remember the dismal record of active managers, and allow your plan to do its thing.

#5 Loss Aversion

“Let’s just play it safe.”

This is the flip side of overconfidence. If overconfidence leads to too many risks, loss aversion leads to paralysis. Investors suffering from loss aversion want the benefits of investing, but their fear of losing money is so great that they are paralyzed into inaction. They’re like a boy standing on the side of a pool, unable to bring himself to jump in because he heard people can drown in water.

During a bear market, you can always spot people suffering from this bias because they’re sitting almost entirely in cash or bonds, even though stocks are relatively inexpensive. For these investors, the mere potential of losing in the stock market outweighs any likelihood of increased returns.

Understanding how your plan works and which investment tools manage risk can help keep loss aversion to a minimum.

#6 Sunken Costs

“I just need to make my money back.”

It’s hard to admit defeat. In the face of overwhelming odds, we will fight tooth and nail just to scratch our way back to even. It makes for some extraordinary tales of unexpected victories.

Unfortunately, those stories are not the norm.

With investments, when we buy something and it sinks, we’ll often hold it until it goes back up to what we paid for it. You wouldn’t want to sell it at a loss, right? The only problem with this approach is that it leads to investors throwing good money after bad.

By refusing to let go of past losses – or gains – and insisting on going down with the ship just because we’ve “come this far,” we end up losing more than we would have otherwise.

Advance Your Un-Bias

These six biases are just a sliver of what’s out there. The field of behavioral finance is fascinating, and studying it has helped us understand both professional and personal areas.

But, if you’re interested in learning more, be aware that merely understanding where biases lie doesn’t mean you’ll always avoid them. Knowing where every obstacle on your financial journey lies makes them known, but they’re still obstacles.

In our view, the best way to avoid behavioral bias is with the help of a third party who can help identify when it may be clouding your judgment. That way, you have someone who can keep you on the path to your goals, no matter what your emotions are saying.

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