The ABC's of Behavioral Biases
In the coming months, we will be sharing a series of articles about behavioral biases and the impact on investment and planning decisions. As financial advisors, it is our role not only to help our clients successfully plan for and invest in their future wealth, but also to act as a coach, helping clients to better understand wise investing strategies and the long-term, global approach that we take in our wealth management process. Our goal is to guide clients to make decisions that serve their best interest. We encourage you to provide us with feedback as each new article is released and we look forward to an active dialogue on the subjects. Enjoy!
By now, you’ve probably heard the news: Your own behavioral biases are often the greatest threat to your financial well-being. As investors, we tend to leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards.
WHY DO WE HAVE BEHAVIORAL BIASES?
Most of the behavioral biases that influence your investment decisions come from mental shortcuts and filters we depend on to think more efficiently and act more effectively in our busy lives.
Usually (but not always!) these short-cuts work well for us. They can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we simply have information overload or have to act fast with the host of deliberations and decisions we face every day.
WHAT DO THEY DO TO US?
As we’ll cover in this series, these systematic errors in judgement can turn deadly in investing. Human emotions and cognitive errors within financial decisions can impact overall financial health.
Behavioral biases are a formidable force. Even once you know they’re there, you’ll probably still experience them. They trick us into wallowing in what financial author and neurologist William J. Bernstein, MD, PhD, describes as a “Petrie dish of financially pathologic behavior,” including:
- Counterproductive trading – incurring more trading expenses than are necessary, buying when prices are high and selling when they’re low.
- Excessive risk-taking – rejecting the “risk insurance” that global diversification provides, instead over-concentrating in recent winners and abandoning recent losers.
- Favoring emotions over evidence – disregarding decades of evidence-based advice on investment best practices.
WHAT CAN WE DO ABOUT THEM?
In this multi-part “ABCs of Behavioral Biases,” we’ll offer an alphabetic introduction to investors’ most damaging behavioral biases, so you can more readily recognize and defend against them the next time they’re happening to you.
Here are a few additional ways you can defend against emotionally or cognitively biased behavior:
Anchor your investing in a solid plan – By anchoring your trading activities in a carefully constructed plan (with predetermined asset allocations that reflect your personal goals and risk tolerances), you’ll stand a much better chance of overcoming the bias-driven distractions along the way.
Increase your understanding – Don’t just take our word for it. Here is an entertaining and informative library on the fascinating relationship between your mind and your money:
- “Predictably Irrational,” Dan Ariely
- “Why Smart People Make Big Money Mistakes,” Gary Belsky, Thomas Gilovich
- “Thinking, Fast and Slow,” Daniel Kahneman
- “Mind Over Money,” Brad Klontz, Ted Klontz
- “The Laws of Wealth,” Daniel Crosby“
Don’t go it alone – Your brain has a difficult time “seeing” its own biases. Having an objective advisor who is well-versed in behavioral finance, dedicated to serving your highest financial interests, and unafraid to show you what you cannot see for yourself is among your strongest defenses against all of the biases we’ll present throughout the rest of this series.
As you learn and explore, we hope you’ll discover: You may be unable to prevent your behavioral biases from staging attacks on your financial resolve. But, you stand a much better chance of thwarting them once you know they’re there!
In our next piece, we’ll begin our A–Z introduction to many of the most common behavioral biases.
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