Common Investor Biases and How They Can Impact Your Finances
We all have different philosophies when it comes to investing our money. Some of us prefer to manage our investments ourselves, while others may want advice from a professional. Regardless of how you manage your money, we’re all human. Which is to say, we all have biases that can affect the way we invest. Some may have cognitive biases—thinking a certain way or following a rule of thumb because of tradition or a particular school of thought. Others may have emotional biases—making decisions based on how something feels instead of facts.
Here are some of the most common investor biases and how to avoid them.
Confirmation bias can happen when an investor makes an assumption or has an existing belief about an investment and looks for information to back up their opinion. Preconceived notions aren’t always accurate, so it’s important to keep an open mind and take a look at all facts when considering new investments.
One of the best ways to counteract confirmation bias is to play devil’s advocate with yourself or your financial professional. Ask, “What if the opposite were true?” This way, you’re looking at all sides of your investment decisions before making them.
Investors who have a loss-aversion bias often take less risk because of an underlying fear of poor outcomes. Not only will these types of investors stay away from high-risk investments, but they may also hold onto losing investments for fear of facing the fact that they made a bad decision.
Understanding your risk tolerance is key to dealing with a loss-aversion bias. How much can you afford to lose and how much are you willing to lose when it comes to your investments? By deciding to invest, you’re accepting the risk that you may lose money, but it’s up to you to decide just how much risk you’re willing to take.
Those who have a familiarity bias are more likely to stick to investments they’re comfortable with, leading to less diversity in investments overall. Investors with this bias tend to stay away from unfamiliar stocks, bonds and securities, which may mean a greater risk of loss.
Be sure to make a concerted effort to cast a wider net when investing. The U.S. Securities and Exchange Commission reports that the average investor holds three to four stocks, but the best practice is to hold at least 300 stocks in your portfolio.
A trend-chasing bias focuses on the idea that historical returns can predict future performance. Unfortunately, excellent returns from an investment last week do not mean that performance will persist, so using only historical data to make investment decisions may lead to a loss.
Instead of making quick investment decisions based on recent news and trends, be sure to do a little more research first. If a company reports good quarterly earnings, that doesn’t mean the next report will be just as good, so it’s worth weighing the risks and benefits of investing.
A truly emotional bias, overconfidence comes into play when an investor thinks they know how to make the best decisions with little or no research. They may try to predict the direction of the market or make rushed decisions based on how they feel. Overconfident investors tend to make more high-risk investment decisions.
If you’re an overconfident investor, it’s important to do all the research you can before making a decision. Alternatively, if you’d like to embrace your overconfidence, you may consider keeping a separate pool of funds to experiment with without risking your core investments.
Financial Professionals Can Help
While we all have our biases, financial professionals have the tools and experience to minimize the impact of these biases on investments. Having a third party involved in guiding your financial decision-making process can help keep you on track and investing efficiently and effectively.