Over the past few weeks, we’ve been delving into the study of behavioral finance and what it means for us as investors. We’ve learned about the rational economic man, cognitive dissonance, and the difference between a good company and a good investment. This week we’ll wrap up our series by looking at the other type of behavioral biases: emotional biases.
Unlike cognitive errors which result from faulty reasoning, emotional biases are a result of attitudes and feelings that we have, making them harder to correct. They are also more dangerous than cognitive biases because they result in impulsive decisions that can have significant consequences. If you’re concerned that your emotions may be getting the best of you when it comes to your money, consider some of the following biases and ask yourself if you find yourself resonating with any:
Overconfidence bias: a bias in which investors have a higher than warranted faith in their own abilities.
For example, most people will say that they’re above average drivers. A surprising number of individuals will also say that they saw the stock market crash of 2008 coming. The former is statistically impossible and the second is highly unlikely, but both imply that individuals have a tendency to think very highly of their abilities. When it comes to investing this can result in unwarranted risk-taking that can have devastating effects.
Regret-Aversion bias: a bias in which investors tend to avoid decisions and actions out of fear that they will have poor results.
For example, I have, on many occasions, impulsively purchased a pair of shoes out of fear that if I don’t I will regret my decision later that night. For investors, this looks like failing to buy into a down market out of fear that it will continue to fall and the investor will have to deal with the pain and regret of their decision. However, what ends up happening is that the investor, paralyzed by fear, misses out on the eventual upswing as well. When it comes to regret-aversion it is crucial that the investor has a disciplined approach to investing such that decisions are driven by rational thought processes and data as opposed to fear of regret.
Status Quo bias: a bias in which investors choose to do nothing, thereby maintaining the status quo as opposed to making a change that may be beneficial in the long run.
For example, for the longest time I went to the same hairdresser to get my hair cut even though I knew that I could get a better haircut for less elsewhere. Despite being discontent, I felt an emotional pull not to disrupt my routine with change. For investors, this emotional bias can lead to a very poorly constructed portfolio because it keeps them from selling losers and/or diversifying across other asset classes. It can also be a detriment to individuals when it comes to financial planning and a fear of seeking out other information and advice out of a sense of loyalty or fear of change.
When it comes to overcoming emotional biases, education is key. The more you know and the more you question things the less likely you are to make impulsive, emotional decisions and the better off you are. When it comes to investing it’s always good to have a healthy dose of skepticism and be aware of how your emotions affect your decision making. If you’d like to learn more about how your behavior can affect your financial decisions, feel free to check out some of our other articles on the topic or give one of our advisors a call.
Institute, CFA. 2016 CFA Level III Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors. CFA Institute, 07/2015. VitalBook file.