“Men willingly believe what they wish.” – Julius Caesar
The Roman Emperor Julius Caesar was alluding to bias, which happens when individuals process information around them and then stick to their preconceived ideas. Bias can happen in financial matters too, and even the most seasoned investors are subject to them. When dealing with emotions, investors are routinely warned about not allowing them to influence their decisions. They are, however, less routinely cautioned about letting their preconceptions and biases color their financial choices.
In a battle between the facts and our preconceptions, our preconceptions may win. If we acknowledge this tendency, we may be able to avoid some unexamined choices when it comes to our finances; it may actually “pay” us to recognize our biases as we invest. Here are some common examples of bias creeping into our financial lives: 1
- Valuing outcomes of investment decisions more than the quality of those decisions. An investor thinks, “I got a great return from that decision,” instead of thinking, “that was a good decision because ______.” How many investment decisions do we make that have a predictable outcome? Hardly any. In retrospect, it is all too easy to prize the gain from a decision over the wisdom of the decision, and to, therefore, believe that the decisions with the best outcomes were in fact the best decisions (not necessarily true).
- Valuing facts we “know” & “see” more than “abstract” facts. Information that seems abstract may seem less valid or valuable than information that relates to personal experience. This is true when we consider different types of investments, the state of the markets, and the health of the economy.
- Valuing the latest information most. In the investment world, the latest news is often more valuable than old news, but when the latest news is consistently good (or consistently bad), memories of previous market climate(s) may become too distant. If we are not careful, our minds may subconsciously dismiss the eventual emergence of the next bear (or bull) market.
- Being overconfident. The more experienced we are at investing, the more confidence we have about our investment choices. When the market is going up and a clear majority of our investment choices work out well, this reinforces our confidence, sometimes to a point where we may start to feel we can do little wrong, thanks to the state of the market, our investing acumen, or both. This could be dangerous.
- The herd mentality. You know how this goes: if everyone is doing something, they must be doing it for sound and logical reasons. The herd mentality can lead many investors to buy high (and sell low). It may also promote panic selling. Above all, it encourages market timing – and when investors try to time the market, they may frequently realize subpar returns.
Sometimes, asking ourselves what our certainty is based on and what it reflects about ourselves can be a helpful and informative step. Examining our preconceptions together with a financial advisor may be a step in this direction. The two following tactical investment approaches could also assist us in addressing these biases: 2, 3
Asset Allocation – This investment strategy used in portfolio management assigns a percentage of your assets to different classes of investments, which are designed to suit your risk tolerance and financial objectives. Asset allocation can be a big picture strategy to provide a framework for investment decisions, which may reduce the temptation for market timing and encourage long-term investment goals. 3
Risk Tolerance – Understanding how much risk you may want to take on is an important consideration in investing. Knowing how much risk you are comfortable with may also help the behavioral bias of loss aversion, where some investors feel the sting of loss twice as much as an equal size gain. 4
In order to best serve your long-term investment goals, it may be wise for investors to take into account these financial preconceptions when customizing investment plans.
1 – forbes.com/sites/theyec/2018/12/14/three-psychological-biases-that-prevent-effective-financial-management [12/14/18]
2 – investopedia.com/advisor-network/articles/051916/8-common-biases-impact-investment-decisions/ [04/12/17]
3 – money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2011/07/27/6-reasons-you-need-an-asset-allocation-strategy [07/27/11]
4 – theemotionalinvestor.org/wp-content/uploads/2012/05/Risk-vs-Loss-Aversion.pdf
This material was prepared using third party resources, and does not necessarily represent the current views of The Goff Financial Group which are subject to change without notice. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering tax or legal advice. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as financial, investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This document is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.