When making investment decisions, you may evaluate a myriad of factors, including your cash flow, allocation targets, and tax trade-offs. What can sometimes be overlooked is how many non-financial factors, such as fear or overconfidence, may also influence decisions.
Behavioral science is the study of how our emotions shape our financial decision-making. Understanding the role of our emotions and biases can help us better manage investment expectations and align our decisions with strategies that are informed and grounded in data.
We’ll share common behavioral and cognitive biases to be aware of and explain why adopting a long-term investment approach can help address them.
What is Behavioral Finance?
Behavioral finance is the study of how human behaviors, emotions, and patterns can shape our financial decision-making. These tendencies don’t always influence us in practical or logical ways, which can help explain why investors may not act in their own best interest, despite having trusted information or guidance. Examples include panic selling during a market downturn and making decisions based on headlines.
Market fluctuations are part of a normal market cycle, which we can’t control. However, what we can control is our response, so understanding how we can address these cognitive and behavioral biases is essential to weathering every stage.
What Are Common Behavioral Biases in Investing?
Behavioral biases, or these tendencies we all have when making decisions, are completely normal but can still negatively affect our risk and long-term outcomes if left unchecked. Here are the common behavioral biases in investing:
What Is Recency Bias?
Recency bias assumes recent outcomes will continue indefinitely and override historical data. For example, you may feel overconfident during long periods of strong yields or fearful amid market swings. Each is part of a normal market cycle, so understanding this can help you maintain a long-term perspective rather than focusing on short-term outcomes.
What Are the Signs of Recency Bias?
If you find yourself taking on more risk than normal due to recent gains or wanting to pull investments due to recent losses or urgent headlines, you may be experiencing recency bias. In these moments, it’s important to refer to historical data, reference your established investing principles, and consider how your reactions to short-term outcomes may be affecting your progress toward your long-term goals.
What Is Herd Mentality?
Closely linked to recency bias is herd mentality, in which investors make decisions based on the actions of others rather than their own investor profile. Investors tend to act as a group, which can feel safer amid urgent headlines or during periods of positive market performance, even if it means deviating from their long-term plan or taking on more risk.
What Are the Signs of Herd Mentality?
Herd mentality can show up as investing in trendy, albeit high-risk assets or selling quickly because “everyone’s doing it,” feeding our fear of missing out. To overcome herd mentality, it’s important to reduce outside noise from friends and the media, pause before acting, and evaluate your long-term plan, not others’ situations.
What Is Loss Aversion?
Loss aversion is the disproportionate negative response investors have to losses compared to similar gains. These negative emotions can prompt investors to avoid loss and risk altogether, even though long-term outcomes often outweigh occasional market downturns and some risk may be necessary to reach their goals.
What Are the Signs of Loss Aversion?
Loss aversion may lead you to stick with safe investments even when they don’t keep pace with your goals or inflation, or to hold on to underperforming assets to avoid a realized loss. While no one likes to “lose,” balancing your comfort level with strategic risk is a key component of long-term investing. When you feel your emotions taking over, remember to reframe market declines as a temporary and normal part of market cycles. You can also review how diversified your assets are to help spread risk, and how you can use risk to support your time horizon and goals. For example, you may take on more risk in growth-oriented years and focus on low-risk investments before retirement.
What Is Home Bias?
Home bias in investing is the overweighting of local or national investments because they feel more familiar and safe. Choosing only investments from your own country or region can lead to underestimating the benefits of global diversification.
What Are the Signs of Home Bias?
If your portfolio overly favors domestic assets, or if you feel foreign investments are inherently riskier or more complex, you may have home bias. When you fall into this trap, remind yourself that familiar doesn’t always mean low risk. Revisit your diversification targets and consult a trusted financial advisor to help explain how global exposure can help smooth risk and support long-term outcomes.
What Is Confirmation Bias?
Confirmation bias is the tendency to invest in an asset based on information that reinforces your beliefs rather than focusing on the bigger picture or data that may challenge them.
What Are the Signs of Confirmation Bias?
Confirmation bias is common when investors only seek out sources or information that support their views, or ignore or dismiss credible warning signs. To overcome it, consider how familiarity or narratives may be overriding evidence and data in your decisions. It’s also helpful to seek out opposing viewpoints and review your plan regularly to identify underperforming strategies that may have gone unchallenged.
How Can Investors Manage Behavioral Biases in Investing?
Behavioral biases in investing are normal but can lead to missed opportunities, misaligned risk, and costly shortfalls. At CCMI, we’re well-versed in behavioral finance and its critical role in our clients’ decisions. Using our expertise, we can help investors recognize and understand their patterns and mindsets to better separate their emotions, plan with intention, and make decisions based on a long-term, disciplined strategy. To manage behavioral biases, remember to:
- Base your decisions on your personal plan, timelines, and goals, rather than short-term market movements, headlines, or others’ situations.
- Evaluate short-term outcomes, market activity, and commentary in the context of historical data.
- Pause before making a decision, whether you’re feeling fearful or excited.
- Rely on investment fundamentals, such as diversification, standard market cycles, and long-term, goals-based investing.
- Partner with a financial advisor who’s familiar with behavioral finance and can provide perspective and help design a plan that’s intentional, systems-based, and consistent.
While emotions will always be part of investing, they shouldn’t drive every decision. Contact us to learn how we can help you set expectations that support your long-term goals.
CCMI provides personalized fee-only financial planning and investment management services to business owners, professionals, individuals and families in San Diego and throughout the country. CCMI has a team of CERTIFIED FINANCIAL PLANNERTM professionals who act as fiduciaries, which means our clients’ interests always come first.
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