Written By Maria Wells
Traditional finance assumes that humans act rationally, but we often do not. Despite our best intentions, we all have behavioral biases that affect the way we think and act. A common problem for investors, biases can lead to reactive changes and poor decisions. The key to combating biases connected to investing is recognizing them and taking steps to overcome them. Below are some common biases that affect investors and steps for overcoming those biases so you can become a more disciplined investor.
Common biases in investing
Availability Bias
One of the most common problems for investors, availability bias, sometimes called recency bias, is when people subconsciously place higher probabilities on recent events or on events that are easier to recall. Availability bias leads investors to believe that outcomes that happened recently are more likely to occur again. For example, investors may buy an overvalued asset due to recent good performance or sell an asset in a market correction. Availability bias can cause overconfident investing, which can fuel volatility in investment prices. Over time, this can and can lead to bubbles and crashes.
Conservatism Bias
Conservatism bias causes investors to maintain their prior beliefs and fail to appropriately incorporate new information into the decision-making process. This can lead to loss aversion, which causes investors to react slowly (or not react at all) to new and critical information. Clinging to previously drawn conclusions can cause an investor to hold onto a security for too long despite more recent negative information. For example, you may hold a stock that’s done well in the past but perhaps due to new technology or an evolving industry, the company’s fundamentals have deteriorated. This new information might mean it’s time to let go of the stock even though it performed well in the past.
Confirmation Bias
Confirmation bias is the tendency to look for data and information that will confirm current beliefs and disregard information that contradicts beliefs. Challenging one’s current ideology can be mentally taxing on investors. It may mean having to update our forecasts or make changes to our portfolios. These adjustments can seem overwhelming at times and maintaining the status quo may seem like an easier path. Selectively choosing which data to utilize can lead to poor investment choices.
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How to overcome investment biases
The first step in overcoming investment biases is to recognize these biases in ourselves. It’s important to understand that we are prone to emotions and cognitive errors that can get in the way of making rational investment decisions. We get overconfident, we get fearful, we react to media hype or pessimism. With that realization, here are several specific steps we can take to overcome investment biases.
Do your homework
Education is an essential tool in recognizing and overcoming biases. Education will help you approach investing with more objectivity. Conducting research on investments rather than just reviewing recent headlines and advertising, is essential for overcoming availability bias. Working with a financial advisor to create a portfolio that will meet your long-term investment objectives and adhering to them despite the noise in between can help you avoid making impulsive decisions based on trends or the most recent craze. Working with a financial advisor can also help ease the burden of sifting through investment data, new information and changing market conditions.
Challenge your thinking
It’s natural to rely on conclusions we’ve already made about an investment, but this can cause problems when we fail to incorporate new information. Ask yourself, “If I didn’t own this stock, would I buy it today?” It’s important to stay up to date on investment data and market conditions and adjust forecasts and portfolios accordingly.
Similarly, it’s important to challenge your conclusions by intentionally seeking information that contradicts your current views.
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How the pros approach investing
As professional family wealth advisors in San Diego California, we take steps to avoid behavioral biases in investing. Our investment management firm does this by having a well-defined process and adhering to it in all our investment portfolio decisions. This forces discipline, which is necessary for overcoming behavioral biases.
Our process starts with understanding each client’s financial situation, objectives, time horizon and risk tolerance. We then apply a consistent approach that calls for controlling risk, maintaining a long-term focus, minimizing costs, and factoring in new information while not falling prey to market “noise.”
By sticking to a prudent and consistent approach, you can make better investment decisions. This will help you stay confident through market ups and downs and reach your financial goals and objectives.
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