In one way or another, we all have a complex relationship with our own money. Because of that, it’s hard to be rational all the time in how we use it. But where do our behavioral biases come from, and what can we do to counteract them? We explore these questions below.
Emotions Lead to Behavioral Biases
Many of us set budgets, monitor our investments and spend conservatively. In doing so, many of us like to think that we are acting rationally with our money. But the truth is, we are emotional when it comes to our finances and that can affect our decision-making.
Common emotions that influence how we spend and invest include:
In terms of investments, this could lead to decisions that impact your portfolio in the long run. For example, you may choose to “follow the crowd” due to fear of missing out (Recency Bias, Chasing Heat) or sell shares impulsively when stocks start trending down (Myopic Loss Aversion).
Emotional spending (Retail Therapy) is another common practice influenced by behavioral biases. When you’re unhappy or upset, buying something new can make you feel better (at least for a little while).
You’re not alone in your behavioral biases, every single person on the planet has these biases, and you can take action to change the things that may be impacting your financial standings.
What Not to Do
Although it may be tempting, avoid making rash investment decisions based on what you see in the news or hear from friends and family.
For example, you may hear that a CEO of a major corporation is stepping down because of a fraud allegation against him. In turn, your first reaction may be to get rid of your stock in that company. However, this may not be the best course of action. First, any widely known information is already priced into the stock. If it’s in the news, it’s in the price, and already too late to act (see Efficient Market Hypothesis for details). Second, this may not have any impact on the company’s performance – especially in the long run. Instead of thinking about that company’s stock over the span of years or decades, you made an in-the-moment decision based on short-term changes. Your gut reaction was to protect your assets right now (Myopic Loss Aversion), when in reality you may have actually hurt your chances for greater returns down the line.
What Can You Do Instead?
Talk to a Professional
If you know that planning your future spending and managing investments tends to be dictated by your emotions, consider working with a financial advisor. He or she will be able to act as an educated, unbiased third party to guide you through investment decisions and other aspects of your financial life.
It is also vital that you think long-term when making decisions, rather than following trends that will not be beneficial to you in the future.
Being self-aware is an important step in avoiding behavioral biases when it comes to investing. Know your goals and volatility threshold and allow that information to help determine your asset allocation strategy. Doing so should help alleviate some worry regarding your investments and reduce the urge to make choices impulsively. The optimal portfolio is where math and emotion intersect.
Acknowledging and controlling your behavioral biases can help you feel confident in your investment decisions and everyday spending choices. Working with a trusted financial advisor allows an objective third-party to offer educated guidance and direction – without emotional bias.
Know The Behavioral Biases
You can start to identify these biases in yourself, and others, by getting to know what they are and how they work. Below, you will find a list of biases that most commonly affect our financial lives. Do some research and try and identify which biases are strongest in you. Remember, we all have these, every last one of us.
- Myopic Loss Aversion
- Recency Bias
- Framing Effect
- Gamblers Fallacy
- Hindsight Bias
- Sunk Cost Fallacy
- Illusory Correlation
- Confirmation Bias
Have questions? Always feel free to contact us, we are here to help.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.