Our emotional biases at work, sabotaging our financial goals

We covered a bit of psychology in Part 1 of the article. We covered some more in Part 3.

Emotions in action:

Inspite of us being rational creatures (at least we all believe ourselves to be), when it comes to money management we often subconsciously do the bidding of our emotional responses. And this happens regardless of our age, level of education, or occupation.

In the book, Descartes Error, Antonio Damasio, a professor of neuroscience at the University of Southern California says that emotion is a necessary ingredient to almost all decisions. So let us take a look at the emotional/behavioral biases at play in our financial decisions.

Cognitive Biases

Cognitive Biases: Courtesy Business Insider

1) Mental Accounting

There is a tendency amongst us humans to separate our money into different mental accounts based on an array of individual criteria such as the source from which the money came from or the eventual goal of spending the particular amount. We love to assign different functions to our asset groups. For example, how many of us have a secret stash for indulgences or a piggy bank for the world tour we have been planning or a small cash fund for the unlikely emergencies? We all have one or the other such stash of funds or assets.

Though most of us are guilty of mental accounting we often do not realize how illogical we are being when handling these asset classes. It is quite common for us to have a special “money jar” or fund for a vacation or a new car while simultaneously carrying sizeable credit card debt. Rationally speaking it would be more logical to pay off our debts with the help of these ‘special funds’ and reduce the interest burden on us but most of us would never think this way. And if you are wondering why we act the way we do, the answer lies in the personal value that we place on certain assets. For example you may feel that money saved for a new home or for the dream vacation is too precious to be relinquished.  As a result we do not touch this ‘precious’ account even though doing so will actually help us reduce debt and increase our net worth.

This bias also directly enters the investing field when some investors may have certain ‘safe’ investments and a more ‘risky’ portfolio together to provide a cushion against negative returns from risky investments. Though it sounds about right, the issue with such a practice is that despite all the work and money that the investor puts in for maintaining a separate portfolio, his net wealth will oftentimes be similar to what it would have behave been if he had held one larger portfolio.

2) Loss aversion

Kahneman & Tversky in their 1979 research put this very succinctly as “losses loom larger than gains”. Psychologists believe that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. In case of investing behaviors loss aversion may lead investors to hold onto under performing assets in the hope of making good in the future rather than selling them and facing the reality of sustaining the loss and the potential anxiety associated with it.

On the other hand it may also explain why some investors may quickly cash out a well performing investment before it reaches its full gain potential with the aim to gain any amount (even if smaller than what the potential is) rather than suffering any possible  loss in the future. Psychologist Laurie Santos has even observed economic behavior in capuchin monkeys that displays loss aversion; we really did not evolve as much as we think it seems.

3) Confirmation bias

People often tend to believe information or ideas that authenticate their own existing beliefs and opinions. Even in financial considerations this confirmation bias exists strongly. If an investor has a certain belief about market conditions, he or she will gravitate toward information sources that confirm that belief though which may not be reflecting real market situations.

Driven by confirmation bias an investor is more likely to seek information that supports his or her ideas about the potential of an investment rather than seeking information that contradicts it.  This results in faulty decision making since the investor functions with one-sided information and may be dealing with a skewed picture of the markets or financial situation.

4) Hindsight bias

How often have you heard someone remark, “I knew that would happen.”  This oft repeated statement is the hindsight bias at play.

Someone has rightly remarked that hindsight is 20/20. This bias is the sense in most people, after something happens that they somehow knew it all along. This happens because it is easier to remember and comprehend the actual outcomes rather than the many other possibilities that did not materialize. Very few people had foreseen the bubble burst in 1999 or 2008 but on looking back, a lot of people feel that they had seen the signs.

Experiments by Baruch Fischoff also indicate that memory of the past is clouded by our tendency of overestimating the correctness of our past decisions. In investment arena this hindsight bias ends up giving investors a false sense of security in their investment decisions. As per Trent Porter, founder of Denver-based Priority Financial Planning this can lead to “excessive risk-taking behavior and place people’s portfolios at risk”.

5) Recency bias.

This is something most investors are guilty of. Investors believe that the recent trends will continue in the future too. While investing many retail investors tend to go by the recent performance of the asset class, often times investing in it just as it is peaking and about to reverse. Since the investment has been climbing higher recently, investors bias makes them believe that it will continue to do so. Although research has clearly showcased that it is close to impossible to predict which asset class in any given year will be an outperformer but for most investors past performance is a strong driver for judging future performance too as they often do not want to be left behind.

6) Herd mentality.

No man is an island… and this is true even in financial markets. People are social animals even while investing. That’s very true when it comes to investing. Investors are often influenced by their peers and follow trends in investing even if these may not be the right steps as per the investor’s own investing objectives. Investors are often unable to avoid the attraction of following the herd during times of euphoria or panic because after all we all believe there is safety in numbers.

Many authors have said the herd mentality is something akin to the lemming suicide myth. According to the myth, lemmings end their lives by following one another and then jumping off a cliff.

7) Optimism Bias:

This bias is a fallout of humans’ overconfidence in their own judgments. We humans generally believe that our judgments are far more accurate than they are in reality. This is a well-established bias. An interesting statistics reports that 94% of college professors believe they have above-average teaching skills; as we all know most students will disagree with that. Also in any survey close to 85 to 90% of the people surveyed tend to think that the future will be more pleasant and less painful for them.

One can say optimism bias is at play in most decision making and investing decisions are no exceptions. Also referred to as ‘positivity illusion’, optimism bias may also lead  investors to overvalue their own investment results by subconsciously choosing results from their portfolios that  mirror their optimistic self-perception as investors rather than measuring the results of their entire portfolio. This leads them to continue with investments which may not be yielding the right returns.

8) Anchoring bias

Avery strong emotional bias often at play is the anchoring bias. People develop attachments to assets, be it a house or a particular investment which they feel will yield good results. Many times investors get overly attached to a particular investment, assuming it will reach a certain price or they place too much importance on a particular source of information (for example a trusted friend) and thus end up holding on to the asset for longer than they should.

Ways to avoid emotional bias

While most of the discussed behavioural biases are at play on a subconscious level, yet they can be avoided by being more mindful while making investment decisions. It is important to stop and assess your overall objectives or your long term financial plan before making any financial decision and ensure that both are aligned. Doing this will go a long way in helping ensure that the financial actions taken by you are ideal for your objectives and are not overly influenced by others or various biases.

It is often best to take a cue from professional investors who are adept in the field and use very specific criteria to choose investments. Experts often rely on various reliable sources of information which an individual may not be privy to. An example is that experts often select companies with solid balance sheets that pay dividends.

A well balanced portfolio is also to quite an extent an assurance of success. While individual investors might understand the importance of diversification to avoid biases at play they may not know how exactly to achieve the same and may go for too simplistic an approach. It is here that an expert will cover your bases and guide you in the right direction for long term investing success and meeting financial plans.

P.S: If you’re more interested to know in-depth about these biases, get onto https://youarenotsosmart.com.

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