And Practical Advice to Help You Avoid Them
By now, most everyone is familiar with the common mistake many investors make when they buy high and sell low. However, it’s not just panic selling that can wreck your portfolio. Your biases and beliefs, even those operating at a subconscious level, have the potential to significantly damage your investment returns and greatly impact your life’s savings.
- Recency bias – This is the tendency to assign importance to recent events. It’s common to believe that because a certain asset class has performed well recently, it will continue to perform well long into the future. Of course, that’s not necessarily true, and this bias may lead you to invest in an asset class at its peak. Additionally, believing an asset class is “due” to perform well because it has not performed well recently can be another form of this bias.
- Mental accounting – Mental accounting refers to a person’s tendency to view different sources of money differently. Of course, we all know that a dollar equals a dollar, regardless of its source. Yet, many people will treat a tax refund or lottery winnings differently than they treat a monthly paycheck. You may be more willing to take risks with unexpected windfalls than you would your own hard-earned income. There’s a chance these risks could lead to complete loss.
- Confirmation bias – Confirmation bias explains our tendency to seek out information that strengthens and confirms our existing beliefs. Any evidence that disputes a strongly held belief is dismissed as incorrect or irrelevant. Confirmation bias can cloud your judgement and lead to poor investment decisions, including missing out on great opportunities.
- Herd mentality bias – One of the most common mistakes many investors make is investing in a financial instrument simply because “everyone else is doing it.” FOMO (fear of missing out) is a powerful driver of behavior. However, it’s important to remember that everyone’s objectives, risk tolerance and investment time horizon is different, and what’s right for the Joneses isn’t necessarily right for you. Falling into the performance comparison trap can lead to discontentment, poor judgment and taking ill-advised, excess risk when making investment decisions.
- Loss aversion bias – Even more powerful than the joy of winning is the fear of losing. Loss aversion bias refers to the phenomenon of feeling a loss more acutely than a win. For example, suppose you invest an equal amount of money in Fund A and Fund B. Fund A grows by 50% while Fund B loses 50%. You’re likely to feel the pain of losing in Fund B more than you feel joy in the growth of Fund A. This can result in having too conservative of an investment portfolio and missing out on the portfolio earnings needed to meet your goals.
- Illusion of control bias – This describes our tendency to believe we have more control over events in our lives than we actually do. Regardless of how often we may tell ourselves that we’ll be able to avoid bad investments and drastic market swings, the truth is, there are many factors we are unable to control. As Benjamin Franklin once noted, “…nothing can be said to be certain, except death and taxes.”
How to Overcome These Biases
Just because you are prone to these biases doesn’t mean you’re doomed to wreck your portfolio. The following tips can help you overcome biased investing.
- Make a plan and stick to it – I believe the best approach is to establish and follow a rules-based approach to investing. Consider your current situation, short-term liquidity needs, goals for the future, particular challenges, risk tolerance, investment time horizon, etc. as you work to develop a detailed plan for investing.
- Sleep on it – Don’t make rash or emotional decisions. Instead, take a logical and rational approach. With your financial plan and rules-based approach as your guide, do your research to determine if a course of action is truly in your long-term best interest. When in doubt, sleep on it for a night or two, and talk it over with a trusted advisor, before making a decision.
- Work with a fiduciary advisor – A qualified fiduciary advisor can help take emotion out of the investment process and will assist you in making rational, informed decisions that support your long-term financial health. Having an unbiased and conflict-free resource can help clear the path to make a well-informed decision.
At Creative Planning, we help clients make wise investment decisions. Our experienced team members provide fiduciary advice that is, at all times, in our clients’ best interest. For help managing your investment portfolio, or for any other financial matter, please schedule a call with a member of our team.