Have you ever felt a knot in your stomach when making a financial decision? Or perhaps an overwhelming sense of excitement? These reactions are more common than you might think. Unfortunately, they can also lead to costly money mistakes. Behavioral finance, a field that examines the psychology behind investment decisions, sheds light on why we make bad mistakes and how to avoid them.
Recognizing Behavioral Biases
Overconfidence, where investors overestimate their knowledge, was evident in the 1990s dot-com bubble. People invested heavily in internet companies with no earnings, clients, or real assets, believing they couldn’t lose in the “new economy.” The subsequent crash was a harsh lesson in humility.
Another frequent pitfall is confirmation bias, where investors seek out information that supports their existing beliefs. This was a major factor in the 2008 financial crisis. Investors were convinced that real estate prices would only increase, and ignored warning signs until it was too late.
Loss aversion, the fear of losing money, can paralyze investors or prompt them to sell at inopportune times. For example, during the COVID-19 pandemic, the stock market plummeted, as many investors sold their holdings in a panic, missing out on the subsequent recovery.
Following the crowd can also lead to poor investment decisions. The GameStop frenzy in 2021 is a perfect example. Social media hype drove the stock price up, not because of the company’s fundamentals, but due to sheer speculation.
Anchoring is a cognitive bias where individuals place too much importance on the first piece of information they encounter, skewing subsequent decisions. For example, an investor who buys a stock at $100 becomes anchored to this price and might irrationally hold onto it if it drops to $80, hoping for a rebound despite evidence of further decline.
Tips to Overcome Biases
Set Clear Goals: Start by setting clear financial goals. Understand where you are now and where you want to be. This process, which we call “Profile Visioning™,” helps you stay focused and avoid making impulsive decisions.
Diversify: Spread your investments across various asset classes to potentially reduce the risk of significant losses.
Regular Reviews: Review your portfolio with a financial advisor at least annually. Professionals provide objective perspectives to keep you on track.
Educate yourself: Learn about behavioral finance and recognize how your emotions affect your decisions. Awareness of these patterns can help you avoid costly mistakes.
Take the Next Step
If you’re unsure how biases impact your investment strategy, consider professional advice. Schedule a Profile Visioning™ session with us today at profile-financial.com/call to help manage your American assets.
Douglas Goldstein, CFP® is the director of Profile Investment Services, Ltd. www.Profile-Financial.com. He is a licensed financial professional both in the U.S. and Israel. Call (02) 624-2788 for a consultation on how to set up your American assets to meet your financial goals. Securities offered through Portfolio Resources Group, Inc. Member FINRA, SIPC, MSRB, FSI. The opinions expressed are those of the author and not those of Portfolio Resources Group, Inc. or its affiliates. Neither PRG nor its affiliates give tax or legal advice.
Published September 10, 2024.