How Savvy Investors Can Apply Behavioral Finance to Protect and Potentially Grow Their Investment Portfolios
Many of us would love to be the Monopoly guy, a filthy rich, superhuman investment machine walking from one windfall to the next. Unfortunately, real life is more complicated. Not every investment is a winner, markets are complex, and everyone makes mistakes at some point.
This is a natural part of the learning process. However, with a disciplined, informed approach to financial planning and investments, even someone with a modest income can build an impressive nest egg.
Surprisingly, the biggest stumbling block for most people is not market corrections or starting to invest late in life. It is approaching finances in a purely logical manner.
Emotions, learned behaviors, and social influence can all get in the way in sneaky, undermining ways. Thankfully, a science-based approach called behavioral finance sheds light on effective ways to overcome our less productive habits.
Behavioral finance is a powerful, nuanced scientific tool. It reveals common assumptions and misunderstandings about how our financial decisions are made. Understanding it can help you invest better by managing the mental and emotional biases that sometimes control decision-making.
It was developed from the study of why investors often lack self-control and even act against their own best financial interests. Revealing the underlying physiological effects impacting investors and markets, it names and describes the subconscious assumptions that result in questionable investment choices.
These biases are ideas or emotions that unwary investors trust over facts when making decisions. Somewhat like an old, favorite pair of sneakers—that has long lost much of their soles—it is human nature to cling to familiar behavioral go-to-s.
For example, in ancient times, the behavioral bias called herding had a functional purpose. A strength-in-numbers approach evened the odds against saber-toothed predators. At the same time, literally running with the crowd without knowing why could save you from things like a sudden rock slide.
This herding bias is less useful in modern settings. In fact, when it comes to long-term-oriented financial endeavors, blindly chasing crowds can yield disastrous results.
Behavioral finance can provide the necessary clarity to see our financial habits from a new perspective and make better choices by uncovering patterns and assumptions. The goal is not to change you or the reasons why you invest, only to fortify your decision-making.
Productive investing typically has a singular purpose: maximizing your wealth. Whether you aim for a comfortable retirement or a sizeable legacy, growing your nest egg is the initial underlying goal common to all investors.
As fiduciary financial advisors in Minneapolis, we are invested in helping people avoid short-sighted or reactionary decisions. It’s why we share concepts from behavioral finance like loss aversion, which describes an investor’s impulse to sell when the market is dropping.
You may be aware that panic selling will only lock in your losses and that you will miss out on any bounce-backs or the eventual recovery. Unfortunately for many less-informed investors, the dread of loss overrides reasoning, and what might have been a rational response gets sidelined.
Conversely, loss aversion can also drive you to hold onto a stock you purchased too high: Even when logically, you know it achieved its peak and is falling, the fear of regret keeps you from letting go.
The bias makes it seem easier to deny your mistake than to cut your losses and convert what remains of your investing cash into more productive investments. You might never consider behaving this way when you are calmer, but unchecked anxiety and uncertainty can be formidable.
Loss aversion is one of over 100 cognitive biases identified in behavioral finance. While you may not learn them all, understanding that default assumptions and emotions can cloud your investment decisions is a powerful first step in rising above the herd. As fiduciary financial advisors in Minneapolis, we have systems and processes in place to help our clients minimize the impact of unconscious biases.
Behavioral finance categorizes two types of biases investors commonly have: cognitive and emotional. Basically, without understanding behavioral finance, sometimes you may be influenced by faulty thinking. Meanwhile, at other times, your emotions may mislead you.
These tendencies are deeply ingrained and hard to spot. Even highly-educated and experienced investors succumb to them, at times. Cognitive biases describe the faulty thinking habits and misunderstandings that contribute to poor financial decisions.
On the other hand, emotional biases are feelings that cause investors to react emotionally to circumstances rather than responding calmly and rationally. Both biases, left unchecked, can derail solid investing. The good news, however, is that both are fixable.
People often learn through experience or by modeling others. This method works great when learning to avoid a hot stove or stop at a stop sign. It’s much less effective when it comes to investing. Markets are complex and change rapidly. Past performance does not predict future results.
When you base choices on assumptions from past experiences—or other people’s behavior—you are likely to miss crucial details. In fact, these tendencies often distract us from seeking potentially beneficial objective information (and, at times, doing vital research).
For example, someone with a confirmation bias may tend to reject sources of information that do not adamantly affirm their personal beliefs about a particular asset. If they become convinced that GenericCo is doomed, consciously or unconsciously, they will ignore news that the company’s temporary supply-chain-related issues have been resolved.
Reason would require considering all credible timely information from a variety of sources. However, the fact that other companies have had the same supply chain problems and that GenericCo’s problems are now fixed get ignored as though irrelevant. There is no stopping this freight train of presumption.
Simple is good, but oversimplifying complex matters can be dangerous. It’s a natural human tendency to want a clear and simple explanation of how things work. Unfortunately, oversimplifying some investments or investing strategies leads to excessive risk or poor decisions. It can also lead to missed opportunities if the simplified understanding does not reveal the true potential of an investment.
An effective way to avoid the oversimplification tendency is to stay within your circle of competence. Let your understanding and knowledge grow organically over time so you can grasp the subtleties and complexities of different markets and investments. It’s also why some people choose to work with an experienced fiduciary financial advisor.
Sometimes labeled “creeping determinism,” hindsight bias refers to when someone sees the past as having been more predictable than it may have been. Investors with this cognitive predisposition believe that they would have recognized or anticipated the outcome of events before they came to pass.
This is why some refer to it as a sort of know-it-all syndrome. Hindsight bias may cause some distortions of memories of known or believed facts prior to the event(s) in question. In extreme cases, people with this bias may develop a degree of overconfidence in their ability to predict the future.
Similar to cognitive biases, emotional biases can short-circuit an investor’s reasoning. However, they are deeply rooted in personal experiences. You might say that where cognitive biases are based in the brain, emotional biases rise from the gut.
Emotions can be powerful and make you feel like you must act now. In that way, emotional biases have a way of blindsiding even typically level-headed investors.
Some people struggle to let go of assets that have lost so much value that they cannot bear the thought of letting them go. Clearly, selling the stock to invest in something better would be the logical way to go.
Nevertheless, dread of admitting that the loss is real—and no longer just digits on a monitor—keeps them from loosening their grip. Their brain may know that it is irrational, but their gut will not allow a positive change to be made.
Investors with a status quo bias are stuck in a loop. They adhere to a set investment strategy and will never consider a new one, even when it could prove far more profitable. Assuming that things will never change for the worse if they keep doing the same thing, they adamantly refuse suggestions of even a tiny change.
In time, the exact opposite can prove to be true. Because they forget that the markets themselves are neither static nor unchanging, their refusal to budge can find them on a collision course with unexpected risks that adjustment might have avoided.
Conversely, like a boat left adrift, their portfolio can wind up entirely risk-free—and, therefore, far into stagnant backwaters where significant ROI is miles out of reach.
Somewhat like loss-aversion, this bias occurs when people favor a blind presumption that the assets they own are inherently better than anything for sale. It could be shares of a shipping fleet—85% of which lies on the floor of the Pacific due to apathetic maintenance practices.
Nevertheless, in the eyes of the endowed, selling them in order to buy any other assets is a losing proposition. They might be the most intelligent, logical person you could hope to meet, but these things do not matter. Their gut is calling all the shots.
The easiest bias to understand might be an aversion to regret. No one enjoys realizing that they have been wrong. So, this paralyzing fear of failure prevents them from taking even low-risk, high-reward chances.
Granted, doing nothing can be safer than taking exceptional risks. However, in the long term, it severely limits potential returns.
At ViaWealth, we are trained in behavioral finance. This means that we use scalable tools formulated to uncover your biases and help you make better decisions.
If someone walks into our office who cannot articulate their innermost long-term goals fully, we are not afraid to do little detective work. Using software like MoneyMind® and HonestConversations®, we can help you identify both your definition of wealth and negative biases that could otherwise hinder you from reaching it.
We believe that you can see your relationship with money more clearly, as a result. Equipped with improved understanding, you can break the chains of unhelpful subconscious financial habits. That, in turn, usually clears the way for well-informed, intentional decision-making.
Once we reach this point, we can start working on your financial plan together. The goal is to create a realistic map to guide you from where you are to your ultimate monetary objectives. Lastly, to help you keep on target for your goals, we encourage you—not just to be an investor but—to engage in goals-based investing.
This starts with getting honest with yourself: What are your financial dreams? Do you want to retire at 55 (or never retire)? Given a chance, would you retire to a national forest to help foster endangered wildlife?
Investors sometimes dismiss achievable dreams because they don’t think they are possible. However, the good news is that through goal-based investing with ViaWealth, it may be possible to live the life you really want to. The journey often begins with setting realistic short-term, mid-term, and long-term goals and then sticking to them.
There isn’t really an ideal time to start investing. However, as soon as possible is generally best. If you already have a portfolio, we can factor in potential returns from your investments with your monthly income. Your assets might be due for rebalancing, but we handle that sort of thing every day.
ViaWealth is a fiduciary firm, which means that we are legally obligated to put your financial interests first every hour of every day. We strive for transparency in all that we do because if you were the advisor and we were your client, that is what we would want in your shoes.
Since we are a fee-only independent fiduciary firm, we are not hindered by the conflicts of interest that can compromise some broker-dealer’s recommendations, either. At ViaWealth, if we recommend an asset to you, that recommendation comes strictly because we believe that it would make a positive addition to your portfolio. We do not charge hidden fees; everything happens in plain sight.
Our experience, expertise, and values have led to the success we enjoy today. While we never guarantee results (lacking a means of telling the future), we believe that we can help you overcome cognitive biases. Contact us today to find out more.
ViaWealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.