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Top 5 Biases That Impact Investment Decisions

As a Private Wealth Manager, I use facts and logic to guide our clients through investment decisions, rather than emotion. Even the most perceptive investors, armed with years of market experience, can fall prey to mental biases that lead to poor investment decisions. While it’s impossible to completely eliminate mental biases, we help our clients identify and minimize common investment biases that can lead to costly investment mistakes.

What are the most common biases in investing?

Behavioral psychologists Daniel Kahneman and Amos Tversky first explained the biases that inhibit investors’ ability to make rational economic decisions. There are two main categories of investing biases: cognitive and emotional.

Cognitive investing biases involve information processing or memory errors, whereas emotional investing biases involve taking actions based on feelings rather than on facts. Let’s take a look at the 5 most common investment biases, along with remedies we use to minimize their impact on our clients.

1.  Confirmation Bias
It is natural for investors to be drawn to information that supports their existing views and opinions. Confirmation bias leads investors to attach more emphasis to information that confirms their belief or supports the outcome they desire. This can have a negative effect by reducing diversification and causing investors to overlook signs that it is time to make adjustments.

How We Help Minimize the Effects: We provide our clients with up-to-date information gathered from a variety of reputable sources.  It is our goal to inform investors on both the pros and cons, giving a more balanced view that leads to better decisions.

2.  Overconfidence Bias
A common behavioral bias in investing is overconfidence, which causes investors to overestimate their judgement or the quality of their information. This can lead to “doubling down” on a losing investment instead of knowing when to cut losses, or under-reacting to important information about changing market conditions.

 How We Help Minimize the Effects: We help our clients develop and stick to a plan and then make adjustments that are based on logic rather than emotion.

3.  Recency Bias
Investors who suffer from recency bias have a tendency to overvalue the most recent information over historical trends. For example, recency biases can threaten an investors’ financial well-being by spurring them into increased risk-taking after experiencing a favorable gain in their portfolio.  It can also occur when the investor experiences an isolated loss and decides not to make any portfolio adjustments for fear of further loss.

How We Help Minimize the Effects: We help our clients focus on the long-term performance of their portfolios, by reviewing both historical and current performance.

4.  Loss Aversion Bias
Research has shown that humans feel the pain of a loss approximately twice as much as they feel the pleasure of a similarly sized gain. This can lead investors to focus on their investment declines more than gains and can lead to inaction that stagnates the growth of their portfolios.

How We Help Minimize the Effects: We help our clients accept that losing money at times is an inevitable part of investing. We work together to create a financial plan that is prepared for both good and bad times with predetermined strategies for both.

5Anchoring Bias

Anchoring bias is the tendency to “anchor” on the first piece of information received rather than evaluating the market as new information develops. For example, when investors anchor their belief about the value of a stock at the initial trading price rather than the current market conditions, this can lead to unwise decisions that can damage their portfolio’s profitability.

How We Help Minimize the Effects: We help our clients to assess investments based on current market environment.

Investing biases can lead people into making financial decisions for reasons other than factual market conditions, significantly diminishing their long-term financial stability. That’s why I believe one of our main responsibilities is to help our clients avoid the cognitive and emotional biases that can lead to faulty investment decisions.

(Keywords: common investment biases, cognitive investing biases, behavioral bias in investing)

Sources:
Parker, Tim. (2018, May 3). Behavioral Bias: Cognitive Versus Emotional Bias in Investing [Blog post] Retrieved from https://www.investopedia.com/articles/investing/051613/behavioral-bias-cognitive-vs-emotional-bias-investing.asp

McKenna, Greg. (2014, Nov. 20) Trading Insider: 5 Cognitive Biases That Can Hold Traders Back [Blog post] retrieved from https://www.businessinsider.com.au/trading-insider-5-cognitive-biases-that-can-hold-traders-back-2014-11

Lazaroff, Peter (2016, April 1) 5 Biases that Hurt Investor Returns [Blogpost] Retrieved from https://www.forbes.com/sites/peterlazaroff/2016/04/01/5-biases-that-hurt-investor-returns/

DesignHacks.co (2017, August). Cognitive Bias Codex [Infographic]. Retrieved from http://www.visualcapitalist.com/wp-content/uploads/2017/09/cognitive-bias-infographic.html

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

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