When I talk to people about taking control of their financial future (your cash flow, risks, investing in line with your goals), they want to talk about investment philosophy, asset allocation, and rates of return. All important aspects in traditional finance but not as essential as discussing the psychology of money.
Traditional finance is built on the assumptions of:
• Rational individuals
• Perfect information
• Efficient markets that quickly absorb new information
The way you think about money directly impacts how you behave with money. Your personal beliefs and experiences influence how you approach life and money. The experience of a first-generation immigrant who witnessed their parents struggle to make ends meet and spend everything they had on their children is in contrast to serial entrepreneurs unable to manage their risks and increase their probability of success.
Behavioral finance acknowledges that people aren’t economic machines. We are weird. We don’t always act rationally, don’t consider all available information when making a decision, and make mistakes when processing things.
There are emotional and cognitive biases. If an individual is experiencing an unconscious emotion or is unwilling or unable to change their view, they are probably dealing with an emotional bias. It may be a cognitive bias if the issue can be easily overcome or changed via education.
Cognitive errors are usually a result of one of two things:
1) An inability to analyze information properly OR
2) Having incomplete information in the first place
I highlight nine cognitive-behavioral biases about money that can unconsciously lead you to handle money differently. They are also easier to overcome.
1. Conservatism Bias
What is it: Individuals maintain their previously held beliefs and don’t incorporate new information. Are you unwilling to update your beliefs? Do you hold onto investments too long?
How to mitigate it: Step back and analyze whether this new information changes your forecast.
2. Confirmation Bias
What is it: Individuals assume that they gather all relevant facts and data before making an informed decision. But they don’t. They usually come to a conclusion and selectively choose the information that agrees with their preconceived notions.
Do you have a decision-making process that only finds what you want to see? Is your portfolio under-diversified (too much employer stock)?
How to mitigate it: Seek and carefully consider the information that contradicts your opinion. Don’t just speak with your colleague who works at the same company or the parents at your child’s school. Use multiple sources and methods of analysis.
3. Illusion of Control
What is it: Individuals are overconfident due to the illusion of knowledge or belief in one’s ability to influence outcomes, such as picking your own lottery numbers.
Do you excessively trade in your accounts or have inadequate diversification?
How to mitigate it: Understand that investing is about increasing the probability of success, seek contrasting opinions, and be able to explain the rationale behind your decisions.
What is it: Individuals use simple if-then or rule-of-thumb decisions. “IF it looks a certain way, THEN it must be in a certain category.” If Elon Musk said it, then I’ll buy more Tesla stock. If Reddit said Gamestop is heading to the moon, it must be true.
How to mitigate it: Focus on actual probabilities and review historical returns.
5. Hindsight Bias
What is it: A selective memory bias is where individuals tend to remember correct views and forget mistakes.
Do you believe your predictions are more accurate than they were or do you believe you are right more often than you are? This can lead to excessive risk-taking.
How to mitigate it: Consistently remind yourself of the cyclical nature of markets and review the rationale for decisions.
6. Framing Bias
What is it: Individuals view information or answer a question differently depending on the context or how the question was asked (framed).
Do you focus on short-term price fluctuations or news articles?
Mitigate: Consider the source of information and look at information from different perspectives.
7. Anchoring & Adjustment Bias
What is it: Individuals remain anchored to an initial value (expected price) and change from that value.
Do you hold on to a stock longer than you should because you’ve “anchored” it to the higher price you bought it at?
How to mitigate it: Past prices and information provide little guidance on future potential, so be open to new information and take the time to do your research.
8. Mental Accounting
What is it: Individuals place their wealth into different buckets to meet different goals.
Do you spend your ‘fun money differently than your retirement money? Do you fail to consider the risk and correlation on a portfolio basis, under-diversifying the buckets and over-emphasizing income over total return?
How to mitigate it: Understand the correlation between investments and diversification benefits. Create a plan for how to spend windfalls like a bonus ahead of time.
9. Availability Bias
What is it: Individuals focus on the information that is easy to find or focus on easily remembered past experiences.
Do you believe your most easily recalled and understood events are more likely to happen?
How to mitigate it: Have an investment policy statement and focus on long-term results.
The reality is that decisions are influenced by several factors, including our emotions and cognitive biases. Identifying yours and being aware of them helps you avoid them. A financial plan and an objective advisor can guide you in making sound investment decisions.
Adviso Wealth is dedicated to working with people just like you. We want to give you the clarity and confidence you need to achieve your personal and financial goals.
To learn more, visit advisowealth.com or email email@example.com