Emotional Bias in Investing
This article was written by a special guest author and colleague, Stephen Reh. Stephen Reh CFA, MBA, CFP® is the founder of Reh Weath Advisors LLC and https://investwithsteve.com/, a financial advisor in Southern California. Stephen is a member of the National Association of Personal Financial Advisors like David J. Fernandez, CFP® and specializes in financial planning and investment advice.
In the investment world, the human element impacts many of our financial decisions. Let’s look at common biases that can affect investment decisions. One set of biases in behavior finance is Emotional Bias. Emotional Bias is caused by individual predispositions that can affect how someone makes a decision. Emotional Bias is how an individual will frame information and make decisions. An important key is that emotional bias is not deliberate but is a spontaneous reaction. Even as an advisor with training on making optimal financial decisions, I still remain vigilant that these biases are not affecting my decision making process.
Loss Aversion -
This bias is one where someone will focus on gains and losses relative to risk rather than returns relative to risk. Meaning that a 10% loss has a greater impact than a 10% gain in your decision making process. You will commonly see this with investors who are holding on to stocks that have lost money in hopes of gaining it back so they will not have to sell the stock at a loss.
What can you do? First step, recognize there might be a loss aversion. Generally, when people recognize they are having a hard time recognizing the loss, the mere knowledge of it helps them to evaluate other alternatives that may be superior to holding on to the loser.
Overconfidence (Illusions of Knowledge) –
Someone can become confident because they feel they have better information or that they are processing information better than others. This exhibits itself in underestimating risk and setting odds of good outcomes too high vs poor outcomes. Sometimes this bias exhibits itself in excess trading or holding very concentrated risky portfolios.
What can you do? You can keep a record of your decisions including motivation and expectations of the investment. Even on winners, did they make a profit for the reasons you thought or was there another reason? On the losers, did they lose more than you anticipated?
Status Quo Bias –
An individual with a Status Quo bias would be slow to change or react even when it makes sense. For example, an investor that has always been aggressive investors may not want to change their asset allocation to be more conservative even if they recognize that they have become more risk averse.
What can you do? Recognize there might be a Status Quo bias. Develop asset allocation models and other tools and plans that you can implement to mitigate the Status Quo bias.
Endowment Bias –
Individuals place a greater value on investments they own rather than potential future investments. Endowment bias and Status Quo biases are often exhibited together. With this bias, you often see assets that are bought that the investor is familiar and comfortable with.
What can you do? Generally, the endowment bias will show up in the asset allocation. Make sure the asset allocation is appropriate. Recognize there might be an endowment bias and try to look at new alternatives with an open mind.
In general, having decisions making process and plan will help mitigate these biases. If you have any questions about these biases and how they have affect your decisions, give Dave Fernandez CFP® a call. Dave can help make sure your portfolio and financial decisions do not suffer from emotional biases.