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In many situations—especially when overloaded with information—people use heuristics, or mental shortcuts, to help them make decisions. By using a heuristic, you rely on past experiences to help solve complex problems. Heuristics can help you make quick decisions in everyday scenarios, such as taking an alternate route home from work to avoid rush hour traffic. In this case, using a heuristic leads you to a rational decision: taking an alternate route home saves you time and stress.
But when it comes to financial decisions, using heuristics doesn’t always lead to rational decisions. Heuristics can produce heuristic-driven biases, which can negatively affect your thinking about investments.
Heuristic-driven Biases Clutter Your Financial Mind
Unlike machines, people aren’t always able to make decisions objectively; they are vulnerable to emotional, cognitive and social factors that clutter their thought process. This clutter causes biases—or the tendencies to make inaccurate judgments and misinterpretations—that affect our financial thought process.
Biases can develop from a variety of sources, such as your childhood and family, personal experiences, societal influences and more. The next sections focus on three groups of biases:
· Emotional-based biases
· Social-based biases
· Cognitive-based biases
As you read each section, ask yourself: is this bias causing a hang-up in my investment decisions?
Biases Based on Emotions
Your emotions can regularly cause distortion in your investment decision-making—this is an emotional bias. Many times, these biases are instinctive and involuntary, and you may not even know they are affecting you.
Your mood plays a significant role in creating biases. You may be more likely to believe information that gives you a positive emotional effect, and less likely to accept information that gives you mental suffering, even if evidence proves the information is true. Some emotional biases include:
Disposition effect is tied to your emotions—you want to feel pride and avoid regret with your financial decisions. This may cause you to sell your stocks too soon (when the price of the stocks has increased) or hang on to stocks too long (if the stock prices dropped).
To avoid the pain of experiencing a loss in your investment, you may use anchoring-and-adjustment. This is the tendency to fixate on a certain number, called a reference point. Then you compare your reference point stock price to a current stock price and do not adjust sufficiently to new information. The reference point is important to investors because they feel pleasure when they obtain a profit compared to the pain of experiencing a loss.
Optimism bias is the tendency to be positive about investments when you are in a good mood. This bias leads to an irrational line of reasoning in which you think that bad investments only happen to other people, not to you.
Overconfidence effect. Overconfidence can be a costly downfall for investors. In this case, you overestimate your own ability to pick stocks with the best returns and the best times to buy them. More times than not, this bias leads to surprises when the stock market doesn’t play out as you anticipated. As a result, many overconfident investors are prone to buying and selling stocks more frequently.
Similar to the overconfidence effect, the illusion of control bias is the tendency to think you have more control over investment outcomes than you really do. As a result, you underestimate the risks involved in your investments. If your investment turns out well, you believe your skills and decisions led to its success.
Endowment effect is the tendency to demand much more to sell an object than you would be willing to pay to buy it. Investors tend to hold on to investments that they already own. This is due to the pain associated with giving something up.
Familiarity bias is your preference to invest your money in something familiar to you. This bias strongly influences purchases that people make. They invest in their own company, state or country because they are more comfortable with it, and comfort is a positive feeling.
Biases Based on Social Factors
Social influences—your peers, the media and more—can lead to biases that affect your financial decision-making, including:
Conformity bias is the tendency to behave similar to others in a group, regardless if it goes against your own judgment. The bandwagon effect is another name for this bias.
For example, even if there is evidence proving that investing in a certain company may not have positive results, you may do it anyway just because others in your social circle are doing so. As more and more people adopt an idea, the likelihood of the bandwagon effect increases.
Availability bias is the tendency to weigh decisions more heavily toward recent information obtained from the media. For example, the latest news about a stock can affect your decision to buy that stock.
Biases Based on Cognitive Factors
Over the course of our lives, we develop cognitive biases, which we learn from our experiences. Cognitive biases result from the mind’s limited capacity to process information, and they can cause irrational thinking when it comes to our investments.
Some cognitive biases that lead to flawed financial thinking include:
Representative heuristic is the tendency to categorize a situation based on a pattern of your previous experiences or beliefs about the scenario. For example, if a certain company’s stock performed very well in the past, you think this is representative of how well the stock will perform in the future. As a result, you purchase the stock without considering how the trends in stocks change over time.
Confirmation bias is the tendency to absorb only facts you agree with, and block out information that challenges your belief. For example, if you have an original idea about an investment, you may only seek out information that supports your original belief, while avoiding facts that contradict your belief.
Framing bias is the tendency to react differently to the same information, depending on how it is presented to you. When there are many unknown factors, you can be more vulnerable to framing because you have no data to rely on. An example of this is investing in a company simply based on how well dressed the company’s CFO is, which is an unrelated factor to how well the stock will actually perform.
Gamblers fallacy happens when you misinterpret the law of averages. In the case of a coin toss, you may think: “I flipped a coin five times and got five heads in a row. My next flip has to be a tails because a tail is due.” We erroneously believe that a run in a particular type of random process makes a reversion more likely. However, this is faulty reasoning, as there is still a 50/50 chance that your next toss will result in a head. This misjudgment also applies to investors who sell a stock that has consistently gone up because they feel it’s unlikely the stock will continue to rise.
Declutter Your Financial Mind
Biases clutter your financial mind and prevent you from making sound investment decisions. The first step to declutter your thinking is to identify which biases you may be prone to and understand the consequences for your investment portfolio.
Letting biases clutter your financial thinking can lead you to:
· Underdiversify your portfolio
· Fail to rebalance your portfolio
· Chase performance
· Trade too frequently or too infrequently
· Pay more in taxes and commission fees
Biases based on emotions take more work to fix because they stem from instinctive or involuntary reactions that are not easily eliminated. On the other hand, biases based on cognitive and social factors are successfully addressed through education.
To reduce the role biases play in your financial thinking:
· Identify your investment objectives
· Develop criteria for your investments and stick to that criteria
· Educate yourself with a professional’s fundamental or technical analyses of stocks
· Diversify your investments
· Regularly review your investments and rebalance them when necessary
When it comes to your finances, avoid making crucial investment mistakes by working with your Safe Harbor Fiduciary partner to recognize your biases, make clear financial decisions and meet your investment goals.
Biases: The Driving Force Behind Irrational Financial Thinking