Popular culture has shaped our fantasy that what it takes to make huge bucks is a unique combination of sheer luck, keen intuition, and solid guts. We wish we could also get rich by just winging it. It’s impossible, but in reality, we can’t rely so much on luck or intuition. We need hard work, great deal of smarts and discipline to reach the financial status we aim for.
We are somehow aware of this. As much as possible, we try to temper our emotions with reason, especially when it comes to making financial decisions. We try to assess whether the things we spend on are worth buying. We try to distinguish whether a thing we will spend on is actually necessary or just luho. This works with saving money. But when it comes to investing, will the same discipline and patience be enough? Sorry to burst your bubble, but no.
According to a study by H. Kent Baker and Victor Ricciardi entitled “How Biases Affect Investor Behavior”, however we try to be guided by reason when we make decisions, especially on our finances, as humans, our behavior is largely influenced by our emotions and biases. Generally, we make decisions based on feelings rather than fact. So, how do we remedy this? Let’s look at some facts first.
Your bias may be costing you money
Based on the same study, here are some of the behavioral biases that largely influence our investment behavior:
Prospect Theory. Aside from rational, we are emotional beings. According to the prospect theory, we respond to losses way differently compared to how we respond to gains. We feel good when we gain something, but our tendency is to feel twice as painful when we lose something. Because of this, we may be more focused on the risk of losing rather than on the opportunity of gaining something.
Our fear of losing may be caused by previous experiences of wrong decisions that led us to feel regretful. Thus, we develop a behavior of becoming too careful about taking risks. Prospect theory calls this Regret or Loss Aversion Bias. We don’t want to feel regret when our choices turn out wrong or bring us losses so we try to lessen the negative effect of our choice in case things go south.
Anchoring or Confirmation Bias. It is normal for us to make first impressions when we encounter a new person, thing, or experience. Our first impression may either be confirmed or contradicted by the information we gather along the way. With anchoring, we are inclined to pay more attention to information that supports our position. Even if there is information available that contradicts our first impression, we would likely dismiss it because we don’t want to contradict ourselves.
Disposition Bias. When we invest, we may have the tendency to label our investments as either winning or losing without enough basis. You may hear from a friend or read from an opinion article about an investment worth taking risk or being secure. Regardless of the performance of our investments, our tendency is to hang on to an investment longer if we labeled it as “winning”, or sell “losing” investments prematurely even if they’re performing well.
Our decisions can also be influenced by what we call Familiarity Bias where we choose popular investments even if they’re expensive or even if we know that we will not gain so much from them. Familiarity bias fuels our fear of diversifying investments and leads us to avoid going outside of our comfort zone.
In terms of how our investments contribute to our behavior and how we see ourselves, there may be instances when our investments either become a reason to beat ourselves or build ourselves up. Our investments then become a source of either ego-boost or guilt-trip. This behavior is highly reflected by two investment biases: the Hindsight bias and the Self-attribution bias.
Hindsight Bias happens when we think that a past event could have been predicted if we were only particular about reading hints or signs. The problem with this is, in reality, the event was a product of random circumstances that couldn’t be predicted.
On the other hand, Self-attribution Bias is at work when we give ourselves full credit when our investment turns out successful. We think we are knowledgeable or skillful enough to have caused our success. The down side about this bias, however, is that when our investment decisions fail, we are not humble enough to admit our fault and we tend to blame external factors as the cause of the negative outcome.
Here’s the remedy: keep yourself aware
The good news is we can be in control of our biases. Once we gain awareness, we can make more rational, rather than emotional, investment decisions. Moreover, we can work towards fulfilling our financial goals by doing one prudent thing—financial planning. By having a financial plan, you will be able to plan out specific courses of action without being hindered by your biases.
Work your financial plan out with a professional so that it would be as objective as possible. Your financial adviser can help you figure out ways on how you can achieve your financial goals based on your biases and tolerance or appetite for financial risks. If you have a solid financial plan, you won’t make sudden and unguided investment decisions whenever you feel like it. There’s rhyme and reason for every financial decision you’ll make so you’ll also have the confidence and peace of mind when it comes to handling investment risks and opportunities.
Kent Baker and Victor Ricciardi. “How Biases Affect Investor Behavior”