We like to think of ourselves as rational, logical decision-makers. But the truth is, psychology plays an enormous role in how we behave, especially when it comes to investing.
The emerging field of behavioral finance meets at the intersection of economics, psychology and decision-making. This final field, decision-making sciences, is opening up exciting findings as researchers dig into why humans decide to do what we do.
It should come as no surprise that we all have biases, and when we look at the field of behavioral finance, the following biases highlight the subconscious forces affecting your investment strategy. There are four main biases you should be aware of when considering the management of your portfolio.
Familiarity bias is our inclination to put our money into familiar investments. Familiarity comes from one’s knowledge/experience. This bias leads us to invest in companies we know (i.e. General Electric), and in places we understand (i.e. North America).
Typically, familiarity bias leads people to invest in big, domestic companies. This often results in a lack of diversification. To avoid this bias, consider diversifying your portfolio more by geography and company size.
Over-confidence bias is our inclination to allow our judgment to outweigh objectivity. When this bias rears its head, we see smart people allowing their experience to lead them to choose investments they “know” will succeed. This type of investor tends to have a portfolio based on their confidence that a specific industry, market, company, is poised for growth. To ensure that our over-confidence does not get in the way of investing success, we must first become aware of this bias, then diversify concentrated investments.
Regret-aversion bias is our inclination to avoid being wrong. Ironically, avoiding being wrong can lead us to being wrong! This stems from a fear of missing out on an opportunity.
This bias manifests with investors making unwise decisions when it comes to managing gains and loses. In investing, we see this when clients hold on to losers, because maybe they will go up again. Conversely, when someone has a winner in their portfolio, regret aversion bias can stop one from selling, because the stock just may keep going up. Regardless of whether you are on the losing or winning end of the regret aversion spectrum, both can have detrimental impacts.
Hindsight bias, hints of which can be found in all the aforementioned biases, is our inclination to see past events as predictable, even though there was no way of predicting those events.
Recall your friend saying, “I should have invested in Apple back in 2002!” How could anyone foreshadow Apple’s meteoric growth since then? It was, and remains, impossible. Hindsight is just that, hindsight. So when we look to past events to help us predict the future, our knowledge base is outdated. As Adam Phillips, British psychotherapist, eloquently states, “The past influences everything and dictates nothing.” To avoid this bias, avoid looking at the past to predict the future.
Of course, there are other known psychological forces at play, and myriad known and unknown decision-making factors involved when it comes to behavioral finance. Money is a stressful subject, so it is no surprise that behavioral finance has emerged as an important field of study. Because, if we are not careful investing can be emotionally driven, it is imperative to be aware of our biases if we are to manage successful long-term portfolios.
Jason Gittins, CFP, is a certified financial planner with Willow Creek Wealth Management Inc. (www.willowcreekwealth.com, 707-829-1146) in Sebastopol, one of the leading wealth management firms in California. Willow Creek Wealth Management has been recognized as one of the best registered independent advisory firms in the United States, by the Financial Times. Wealth Matters is a monthly column from the firm’s advisors.