It’s tough to overcome emotional biases in investing because they’re basically embedded filters in our thinking. They’re not usually rational, they don’t help you invest smarter, and many investors are unaware they even have these filters in place to begin with.
While it’s impossible to be completely bias-free when it comes to investing, having an understanding of the most common biases will help you compensate for them.
Read through these six biases and consider which come into play in your investing habits. At the end, I’ll share a few ways you can help overcome these emotional biases and invest smarter.
The six main emotional investment biases
Loss Aversion Bias
No one likes to lose money. In fact, we tend to feel more pain over losing money than we do pleasure from gaining an equal amount. When it comes to investing, loss aversion can make us overly conservative. We fear risk so much that we miss out on significant gain potential. Even more damaging, loss aversion causes many investors to hold onto bad investments for way too long.
This occurs when an investor overestimates their own intuitive ability or reasoning. Maybe the investor works in the sector he or she is investing in and feels they know that market better than most. Or maybe they’ve heavily researched the market and feel sure of their strategy. No matter where overconfidence bias comes from, it can get investors in a lot of trouble when they underestimate uncertainty.
Interestingly overconfidence tends to correlate with a high trading frequency. It seems that the more confident the investor, the more likely they are to believe they can time the market. In reality, research shows the more trading an investor does, the lower their returns tend to be in the long run.
When an investor looks for short-term gains at the expense of long-term ones, they’re probably suffering from self-control bias. It pushes investors to make instant-gratification decisions, like day trading and high-risk investments.
Investors with self-control bias tend to have smaller savings and investment accounts because they also spend much of their income. They avoid investments that tie up their capital because they prefer the option of liquidating at a moment’s notice.
Status Quo Bias
The status quo bias causes investors to prefer sticking to the same path over trying a new investment strategy, updating their portfolio, or branching out with their investments. They expect that things will stay the same over time, so they’re often unwilling to make changes. The status quo bias leads investors to take on unintentional risks (or no risk at all) because they don’t update their portfolio as the market changes.
The endowment bias occurs when an investor overvalues an investment because they already own it, they’ve held it for a long time, or it’s sentimental. Whatever the circumstances are, the investor believes the asset is worth more than it really is. As a result, they may be unwilling to sell the asset for less than their perceived value. Rather than realizing a small, realistic profit, they refuse to sell and realize no profit at all. In some cases, like with real estate, the holding cost of delaying the sale ends up costing the investor more than they would have made by selling at less than their desired price.
Regret Aversion Bias
No one likes to be wrong. But investors suffering from regret aversion bias are paralyzed by their fear of making the wrong choice. Rather than acting on a potentially lucrative opportunity, they choose to do nothing. They believe doing nothing is safer than taking a risk. In reality, omission can be just as risky as a new opportunity.
How to protect yourself from biased investing
Do you see any of these biases creep up in your investing behavior? Often, it’s hard to even be aware of our own biases when it comes to money. Plus, we change overtime. We all go through seasons where our cash flow is tighter or where worry creeps in. This can lead us to irrational moments and poor short-term decision making.
Having a trusted advisor is the most valuable in these moments of short-term stress. Your financial partner helps you acknowledge when emotional biases are putting your finances at risk.
You don’t have to build a bias-protected investment strategy on your own. The financial experts at Cook Wealth can help. We watch the market every day so you don’t have to worry.