By Tim Nielsen, CFP® – Advisor
Read part one HERE
In this two-part blog series, I am going to discuss psychological biases that impact our investment decisions and how to manage it. Countless books and research reports have been written on the psychology of investing and to save you from reading a novel, I am going to provide an overview on two categories of bias, Cognitive and Emotional.
Investing in the Financial Markets can be compared to riding a roller coaster. There will be many ups and downs, twists and turns, and unexpected loops. Your biases on investing will greatly impact how successful you are. Many investors will encounter cognitive or emotional biases along the way. To provide a definition, Cognitive Biases are decisions based on established concepts that may or may not be accurate and Emotional Biases are based on personal feelings or past experiences.
Cognitive Biases – Anchoring and Risk Averse
Anchoring is a bias when you apply a benchmark, such as purchase price, to the stock you just bought. Regardless of what the stock price does going forward, that benchmark will always be on your mind. Fast forward 6 months and the price has decreased 30% due to a failed drug trial but you hold on because you can’t see beyond that benchmark. You have now been anchored and will assume greater risk with the hopes that the price gets back and rises above the anchor point.
Risk-Averse often causes investors to put more weight on bad news rather than good news. Enron, WorldCom, and the 2008 Financial Crisis are still fresh in many investor’s minds. Even though this happened years ago, investors will still put more weight on the bad news. This, in turn, causes portfolios to be more conservative and overweight in safe investments, potentially missing out on much needed growth to achieve the ability to retire comfortably.
Emotional Bias – Endowment & Overconfidence
Endowment Bias is the idea that what an investor owns is more valuable than what they do not own. For all the Fantasy Sports Fans out there. You draft a player that you have always considered great. Halfway through the season, the player has been injured and in a slump. You then get a trade offer, but you refuse or want more because you still think their value is greater than everyone else’s. Owning investments is very similar. Investors become emotionally attached to their investments causing them to put a higher value than what it might be worth, leading to disregard of current market situations and/or new industry leaders.
Overconfidence Bias is thinking that you are more skilled than everyone else. For example, take someone who has worked in the Pharmaceutical Industry for years. They feel like they have better insight than everyone else which causes them to think that they are better investors in that sector. Most likely though, they didn’t predict that a virus would shut down the World. Having overconfidence can cloud your ability to see events that might happen or consider other’s research and opinions.
Cognitive and Emotional Biases have and will continue to influence our investment decisions. Having the ability to navigate those emotions will greatly increase your chances of having a successful financial plan. Stay tuned for part two of my blog which will focus on managing your investor psychology.
If you have any questions or want to start the conversation on managing these emotions, please contact me at tnielsen@monetagroup.com.
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