Financial planning and investing are complex endeavors that require rational decision-making backed by sound research. Unfortunately, we are often our own worst enemies, as human psychology is riddled with cognitive biases, mental traps and fallacies that can distort our perceptions, leading to poor financial choices. Although there are numerous psychological shortcomings we are unfortunately burdened by, I decided to focus on those that I have found to be most damaging when analyzing prospective client’s financial situations.
The purpose of this writing is to raise awareness and encourage self-reflection. Do not beat yourself up if you find yourself aligning with several biases discussed below. Everybody has been there! You might notice that many of these psychological shortcomings can also be applied outside of finance (i.e., sunk cost fallacy and my love for buying problematic and discontinued Italian motorcycles…it has never ended well!)
- Confirmation Bias
Description: This bias involves seeking out information that confirms one's existing beliefs while ignoring contradictory data. “Picking sides” and only engaging within an echo chamber.
Example: An investor who believes renewable energy stocks are the future may only pay attention to positive news about the industry, disregarding challenges such as regulatory setbacks. Confirmation bias is also often noticeable when discussing insurance, as there is a fair amount of conflicting information about the various types of insurances available that lacks any substantial supporting research.
- Loss Aversion
Description: Loss aversion leads individuals to prioritize avoiding losses over acquiring gains. The actual pain of loss is more severe than the pleasure of winning, even when the magnitude of the potential loss vs. gain is the same! This bias often pops up en masse during bear markets, particularly among retirees who are too late to realize the change in their risk tolerance.
Example: An investor sells their risk assets after a period of volatility, locking in losses and suffering the opportunity cost of missing out on future gains.
- Sunk Cost Fallacy
Description: People continue investing in something due to the resources already committed, even when those resources are unrecoverable. This is a big one…often observable in single stock/security pickers. It is also something we have ALL experienced in our personal lives, whether it was a career that you did not enjoy (but stuck with for far too long because you earned a degree/invested in substantial training for it). Or the long-term relationship that was over long before it was officially over.
Example: An investor holds onto a losing stock because they have invested a significant amount of money, even though it no longer aligns with their investment strategy.
- Overconfidence Bias
Description: Investors often overestimate their own abilities, leading to excessive risk-taking and poor decision-making. I also notice this often with DIY financial plans, where there are a number of major considerations not accounted for.
Example: An investor who successfully predicted a market trend believes they can predict all market movements. There is a lengthy list of famous investors and traders (some of whom have entire movies produced about their market calls) who are essentially one hit wonders. There is a major difference between incorporating active management allocations as a form of risk management and outright market timing (which very few individuals, if any, can successfully do in a repeated manner).
- Recency Bias
Description: Investors assign disproportionate importance to recent events, often ignoring historical data. “Recency” can be applied to timeframes that are much longer than we initially realize.
Example: The positive correlation between stocks and bonds in 2022, where both decreased in value simultaneously, caught many investors (who believed that stocks and bonds were always negatively correlated) off guard. Historically, stocks and bonds have shown a dynamic correlation, but you would have needed a deeper understanding of historical market prices to see that risk in the first place, as the most recent negative correlation “regime” had existed for over a decade.
Cognitive biases can cloud investors' judgment, leading to suboptimal decisions that harm portfolios and financial plans in ways that are not easily repaired. Recognizing these biases is crucial for making informed choices. By cultivating self-awareness, seeking diverse viewpoints, and adhering to a disciplined and well researched investment/planning strategies, we can navigate the complex world of finance with more clarity and improved probabilities of success.
2023-165207 Exp 11/25