When you love a partner, a child, or a pet, you want to see the best in them. Focusing on our loved ones’ best qualities (and even exaggerating them a bit) can be the foundation for healthy and harmonious relationships.
However, this same trait does not apply well to asset allocation. In behavioral finance, there are four biases that distort people’s perception of investments’ value, undermining financial success: endowment bias, affinity bias, mental accounting bias, and anchoring bias.
Fortunately, you can avoid making costly mistakes in your investment and retirement strategies by understanding these biases and avoiding them.
To some degree, emotional and cognitive biases are a part of being human. Just as our bodies need certain bacteria to survive, some biases probably hold (or at least once held) functional benefits for us. Nevertheless, some of them, clearly, are more beneficial than others.
Years ago, the science of behavioral finance began giving the financial industry clearer insights into what makes investors tick. Since the role of a fiduciary financial advisor is similar to that of a monetary physician, their advances have been welcomed.
The clearer we can see problems, the easier it is for us to help you stay in good financial health. Better yet, the clearer that we can see potential problems before they arrive, the better we can avoid them. This is what makes recognizing the most counterproductive biases important to your success as an investor.
The idea is not to strain and grunt until you are somehow 100% bias-free (because, in all honesty, that is not realistic). Instead, you will get the most out of what follows by noting the telltale indicators.
Since bad habits are best replaced with good ones, we can train ourselves to observe, “Okay, my endowment bias might be keeping me from solid judgment here: I need to take a few breaths and look at it from another angle before reacting.”
With this in mind, what follows is a breakdown of four cognitive biases that often derail the train of investors’ financial goals.
If you’ve ever bought or sold a home, you may be familiar with endowment bias. There is the market value of the property—and then there is the emotional value of enjoying the space, memories that were created there, and the sweat equity you poured into the house and yard.
Home sellers often feel their property is special and should be worth more than competitive properties. It is worth more to them personally, but this heightened sense of marketable value is a function of their personal experiences and emotional investment. It is not the property’s actual financial worth.
Endowment bias can trip investors up when they either overvalue things they already own or when a salesperson or the media encourages psychological ownership. Someone who is invested in a particular idea will be more willing to overpay. Often they develop an exaggerated sense of its value, as well.
Affinity bias is visible in couples or long-term friends that dress similarly or have matching ways of speaking, catchphrases, or mannerisms. Even a dog and its owner sometimes look alike. People are attracted to others who reflect their preferences, style, values, and appearance.
The challenge with affinity bias happens when an investor puts too much trust in an investment solely because it seems to reflect their values.
A good example of affinity bias was the Bernie Madoff scandal. Many very wealthy people, including celebrities, were drawn into this Ponzi scheme simply because others they knew were also investing with him.
The moral of the story for affinity bias is that just because your neighbor, best friend, or family member may be invested in a particular stock or holding, ask yourself if it’s the right fit for you based on your needs and goals. You should also always do your own due diligence rather than rely on the input of others, especially when it comes to your hard-earned savings.
Related to the disposition effect, this bias identifies a pattern of thinking that undermines investment success. Specifically, without consulting their Kansas City financial advisor, investors will tend to sell a winning investment and hold onto a losing investment. Emotionally, this seems to make sense.
You want to lock in your gains with the winning investment and leave the losing investment where it is in the hopes of regaining what was lost. However, the reality is that selling something on the rise could potentially eliminate future gains. Holding onto a losing stock, hoping that it may improve, could prevent you from converting those funds into more productive investments.
When you are shopping for a pair of boots and see a pair marked down from $580 to $270, you may immediately assume they are a good deal. This is because you’ve mentally anchored the value of the boots at $580, which makes $270 attractive. Even if you were originally hoping to spend less than $225, you may stretch your budget to take advantage of what looks like an opportunity.
This is an example of anchoring bias in action. In investing, it gets slightly more complicated. Let’s say you hear a successful friend or see a reputable magazine raving about a specific investment: They describe several reasons why it’s a winner. Because it came from a source you trust, the idea sticks in your mind.
This is now your ‘anchor’ relative to this investment. Even if other data come in indicating that the honeymoon period for this investment is actually over—or that it is a higher risk tolerance than is appropriate for you—your brain may dismiss it and stick with the initial anchor. Clearly, this can lead to suboptimal investment choices.
Above all, we believe the best way to overcome personal financial behavioral biases is with the help of a friend. At ViaWealth, we like to think of our clients as friends because it reflects our commitment to you as fiduciaries.
We start by learning your personal definition of wealth, your values, and your financial goals. From there, we analyze the data to help you create an optimal long-term financial plan. In times of market volatility, this can include investments for rising interest rates and diversified asset classes.
If you are between advisors, we believe that our experienced experts have the goals-based planning you have been looking for. Let us reduce your interest rate risk. Contact us today and discover the difference.