Cognitive biases and behaviors surrounding money and investing can significantly affect individual’s financial decisions and overall wealth accumulation. While money and investing are often seen as rational and objective matters, human psychology can introduce biases, fears, and irrational behaviors that can hinder one’s long-term financial success. In this month’s blog, we will explore ten common cognitive biases so you can better understand how they may be impacting your decisions when it comes to your money and investments.
1. Loss Aversion
Loss aversion refers to the tendency to feel the pain of losses more intensely than the pleasure of gains. This bias can lead individuals to hold on to losing investments for longer than necessary in hopes of a recovery. It can prevent the reallocation of investments to more promising opportunities.
2. Risk Aversion
Similar to the above-mentioned loss aversion, this refers to individuals being inherently risk-averse and more concerned about avoiding losses than making gains. This fear can lead to overly conservative investment strategies or missed investment opportunities, which may limit long-term growth potential. It is important to strike a balance between risk and reward and not let fear prevent one from taking calculated investment risks.
3. Herd Mentality
This describes the tendency of individuals to follow the actions of others, assuming that if everyone else is doing it, it must be the best choice rather than performing one’s own analysis and research. This can lead to investment at the peak of a market bubble or panic selling during a bear market, amplifying losses.
Anchoring is the tendency to rely heavily on a single piece of information or value, such as a company’s revenue or historical share price. For example, holding stock with significant loss in value because the investor believes the value will rise to the point it was at previously, despite indications otherwise. This can lead to distorted perceptions of value and price as the investor is basing decisions on selective information rather than objective analysis.
5. Confirmation Bias
Confirmation bias causes individuals to seek out information that confirms their existing beliefs while ignoring or dismissing contradictory evidence. This can hinder effective investment decision-making by clouding judgment and preventing objective analysis and research.
6. Endowment Effect
This is when an individual places a higher value on something they already own, often because of emotional or symbolic significance. The endowment effect can negatively impact the diversification of a portfolio or cause an investor to persist in holding an asset that may never have a market value that will match the investor’s expectations. This can occur often with inherited assets such as shares of a company or collectible items.
7. Status Quo Bias
This is the predisposition to no change (to maintain the status quo) when presented with a choice. This is often due to people having discomfort with uncertainty and the desire to stick with what is predictable and familiar. It can lead to missed opportunities, such as switching to a lower cost auto insurance plan or reallocating assets when it is advantageous to do so.
8. Availability, Recency, Salience, and Familiarity Bias
These biases refer to the tendency to hold certain information or companies in higher regard because of it being more readily available or repeated; very recent so as to be more prominent in one’s mind; more vivid or emotionally poignant; or more familiar to the investor and thus feels safer or better understood.
9. Representative Bias
This occurs when a person believes two or more things will behave the same because of them being similar. This can result in assuming two companies will perform the same due to having similar characteristics; that the outcome of one situation will be the same as a similar situation that occurred previously; or that the past returns of a security are indicative of its future returns. This can lead to poor investment decisions because the information being considered is possibly incorrect or irrelevant.
10. Cognitive Dissonance
Cognitive dissonance arises when a person behaves in a way that contradicts their long-held beliefs or attitudes. This can lead to irrational decision making and behaviors and attempting to justify them by changing or minimizing existing beliefs or adding new beliefs.
Recognizing and addressing these biases and behaviors can help individuals make more informed, rational investment decisions and improve the chances of attaining long-term financial success. Your team at Vision Capital Management is an important safeguard against the influence of cognitive biases by regularly reviewing and adjusting investment strategies through an objective lens based on changing market conditions. They are always eager to provide clients with education and guidance to help develop and maintain an investment strategy and diversified portfolio that will enable meeting your unique financial goals.