How Behavioral Investing Can Impact Your Financial Goals
There are up to 188 cognitive biases that impede our ability to make sound decisions. In many scenarios, the effects of our biases may be dismissed as foibles, but there’s not much room for needless mistakes in business.
Behavioral finance theory involves a combination of the fields of Economics and Finance with Psychology. The pairing examines why people make the financial decisions they make and the motivations behind them. Behavioral investing impacts financial goals through;
Investors have an inclination to undervalue gains they make and value more the losses they avoid making. Our impulse to avoid the feeling of loss is stronger than the impulse to seek out profit.
The feeling of satisfaction that accompanies the impulse also supports loss avoidance. An ingrained tendency to avoid losses leads to stagnation given an investor is determined to not take any risks. If one does not take the necessary risks, financial goals cannot be achieved.
The Effects of Overconfidence
Overconfidence involves the overestimation of one’s abilities. A much too favorable view of our own abilities leads to ambitious decision making.
Confidence creates an illusion of control that leads to the overlooking of potential threats or inherent weaknesses. We, therefore, end up setting ourselves up for failure without even realizing it.
The eventual investment bias is usually the culmination of a successful streak where we begin to attribute it to our skills and start to believe we can’t be wrong. We end up setting financial goals we can’t achieve.
The Endowment Effect
The endowment effect with regard to behavioral investing refers to a tendency by people to place more value on investments simply because they own them. We would rather pay more money to retain ownership of an investment than pay less for a new investment.
The endowment effect presents a problem in situations where we stall when the financial goals demand that we let go of an investment. A situation that is made worse when time is of the essence.
Regret Aversion in Behavioral Investing
Investors who make a bad decision and experience the familiar pang of regret once they realize they messed up might try to avoid that feeling seek to play it safe all the time. Regret aversion makes for an interesting pairing with lofty financial goals.
Investors want to reach their goals but find the idea that there’s a probability of loss an unpalatable one. The effect of such a conflict is investors delay their decision-making which could prove problematic when timely decisions are required.
Another problem that arises is the tendency to follow the herd. An example of this can be seen when an investor opts to invest in a hot stock without doing his/her homework. A poor decision that’s easy to rationalize given “everyone lost out too.”
Anchoring is the behavioral financial bias observed most in the real estate sector. Anchoring refers to a tendency to hold onto a position, a value or a principle even when the position is harmful to your financial position.
An example of such a problem can be seen in house owners who are unwilling to sell their houses at a price lower than the price that they purchased it. A house owner who chooses to ignore the realities of depreciation only compounds the problem given he/she would have to sell the price at a much-reduced price.
The same phenomenon is observed in the stock exchange where an investor isn’t willing to sell his stock at a price lower than it was purchased. A harmful position given no positive outcome can result from it. Such a position also goes against the current of progress towards one’s financial goals.
Hyperbolic discounting manifests itself in behavioral investing in scenarios where one has to choose between two favorable outcomes. One outcome requires that you sacrifice current gains in order to make a larger one in the future.
The other outcome is immediate but considerably less. A wise financial goal would align will the first choice. The problem, however, presents itself when the immediate gains start pouring in, and an investor retracts from his position.
Hyperbolic discounting is more often than not reinforced by other biases such as loss avoidance and regret aversion. Investment bias of this sort can be seen in employees who have a problem taking home less pay in order to set aside savings for retirement.
The employee cares about having financial security when he gets older and intends to start saving. The pull of immediate gratification, however, dissuades him from that goal.
We are drawn to information that supports our points of view and actively seek them out. Facts that present an opposing view are often ignored. Confirmation bias can be observed in a scenario where an investor has a strong belief about the state of the market and wishes to decide based on this belief.
Such an investor will seek out all evidence that supports his view and neglect those that don’t. The move could turn out favorably, but the odds of failure are too high to make it a wise business practice.
An investor that considers all the facts makes objective financial decisions and avoids having to set financial goals whose achievement relies on luck.
We so often fall prey to the false belief that we possess some form of predictive ability. This belief is reinforced once we look at a streak of successes and let our ego have free reign.
The assuredness that springs from hindsight bias is the cause of impulsive risk-taking that could severely hurt one’s finances not to mention one’s future when one gets older.
If a particular idea/belief has the tendency to easily come to mind, often we tend to believe to be true. The same can be said for when we hear an idea many times we tend to believe it’s actually the case.
The source of this idea could be friends, social media, and television et al. This tendency to readily accept an idea/belief without giving it due consideration is the result of availability heuristic.
Self-attribution bias is characterized by a penchant for taking the credit for favorable outcomes and attributing failure to anything but oneself. Investors who exhibit this bias tend to do be overconfident which affects their judgment.
If an investor’s first impulse after a negative outcome is to lay blame to external factors, he/she fails to analyze the problem objectively. He/she is thus more likely to make a mistake again and again.
The overconfidence that results from regular self-affirmation encourages impulsive risk-taking which could harm the business. Overconfidence leads to the setting up of lofty financial goals that can’t be achieved.
A drop in fuel prices is almost always accompanied by a rise in car sales. Should this happen, a misconception would be that this state of things will go on for a long time.
The same phenomenon holds true for investors. Retail investors will more often than not risk a stampede joining an asset class due to recent positive outcomes. There’s no way to know that the investment will keep on doing well but a strong belief that this will persist will lead to more investment.
When recency bias is coupled with a fear that one might make losses people toss good judgment out the window. Recency bias could lead to impulse investment that doesn’t cohere with an investor’s financial goals.
An investor who presupposes that that something means something it isn’t is hampered by representativeness. An investor will come across good half-year earnings and assume that will be the case next time.
Representativeness can also be observed when investors assume a good company automatically translates to good stocks. Critical analysis is neglected in favor of quick decision making that feels right.
When representativeness is paired with overconfidence, the mistake can be made multiple times before the lesson is learned. The problem here is that there isn’t much in the name of second-guessing.
An investor who objectively sets achievable goals is also aware of the level of risks that he/she can handle. The tolerable amount of risk will be arrived at after investors first consider their current financial status.
They should then assess how the size of the investment matches up to their portfolio and how long the endeavor will take. Frame dependence manifests itself in a tendency to alter one’s risk tolerance based on market performance.
An investor will raise the tolerance when the market is doing well and acts conversely when it isn’t. Such investors sell low and buy high.
Behavioral Diversification takes the form of Naive Diversification when an investor is in a mad rush to diversify but lacks the necessary know-how. The tendency would be to invest their capital in any option that is tossed their way without doing the necessary homework first.
Diversification of this kind instills a false sense of security and optimism. Naive Diversification given its randomness indicates no set financial goals.
Disposition Effect Bias
An investor with disposition effect bias will arbitrarily judge an investment as good and another as being terrible. The investor will then be obstinate about these judgments regardless of whether the investments perform poorly or not.
He/she will hold on to investments that perform poorly in the hope of a turnaround that won’t happen. Another mistake will be made when the investor sells a well-performing investment early to offset the losses made beforehand and make a net loss.
Such a move will compound the problem given he/she will now have to contend with high capital gains taxes.
Cognitive dissonance has a relationship with disposition effect to the extent that the investor holds on to an investment even when it tanks. Cognitive dissonance involves a conflict of thought and action where an individual thinks one thing but the physical outcome is not congruent with the thought.
Behavioral finance examples in cognitive dissonance would include an investor who discovers his investment is falling and has to react. A natural reaction would be to act in haste, sell off the investments and minimize his losses.
The investor will instead convince himself that his investment was prudent and that a turnaround will happen. Poor returns only lead to a failure to reach one’s financial goals.
Choice paralysis is in a way as an inverse of naive diversification. Objectively speaking, having more investment choices would be a good thing given an investor has a choice to discriminate.
He/She has an opportunity to distinguish a good investment from a bad one. The many options on offer could lead to choice paralysis once the investor is overwhelmed with all this information.
The loss will be acute in scenarios where good investment options are available, but an investor doesn’t even know where to begin. Lack of investment leads to zero progress towards one’s financial goals.
Courtesy bias as a symptom of behavioral investing is unique given it deals with the company an investor keeps. Courtesy bias manifests itself in scenarios whereby an investor surrenders a good idea to that of the consensus.
The need to be polite rather than seen to hold a view contrary to that of everyone else often leads to poor decision making by an otherwise objective investor. As long as the investor will allow the influence of poor decision-makers to cloud his judgment, reaching his goals will be a problem.
What This Means to You
From planning for your child’s college years to having financial security during retirement, it’s important not to let biases and heuristics impede your progress.
The perils that accompany behavioral investing can be overcome if you invite some experts to help you in that regard. At FamilyVest, we have that expertise.
Our mission is to revolutionize how families plan for their future, and we’d love to bring you on board.
Contact us today.