6 Behavioral Finance Pitfalls To Be Aware Of
Let’s face it: we’re not always rational when it comes to money and investing. (Stop me if you’re shocked!) Our biases and emotions can lead us astray. If you’re working a saving toward your long-term goals, it’s helpful to be aware of certain behavioral finance pitfalls. Behavioral finance is the study of how our thinking affects our financial decision-making. Here are some examples.
Overconfidence Bias: Ever been so sure you were right, but then found out you were wrong? It’s okay, we’ve all been there. It’s an easy mistake to make when we’re not experienced, and when we don’t have all the facts. Overconfidence bias is when we overestimate our abilities or the accuracy of our beliefs. Not to call you out, but if you’re leading a successful career, you may be more prone to this bias. Just be cautious: intelligence and skills don’t necessarily translate into investing success. Investing is a complex and ever-changing field, and no one has all the answers.
Herd Mentality: Herd mentality is when we follow the crowd, even if it's not in our best interest. It’s an easy trap to fall into, and often happens subconsciously. Investors may be more susceptible to this bias if they lack confidence in their own investing knowledge or if they feel pressure to conform to societal expectations. However, following the herd can lead to buying high and selling low, or poor investment choices, which are surefire ways to lose money.
Loss Aversion: Loss aversion is the tendency to prefer avoiding losses over acquiring gains. We’re a sum of our lifetime of experiences – heck, we haven’t gotten this far without learning from our mistakes along the way! However, when it comes to investing, calculated risk can be appropriate. We’re not talking betting the farm on a hot stock – we’re just saying that being overly cautious can lead to missed opportunities and stagnant portfolios.
Anchoring Bias: Anchoring bias is when we rely too heavily on a single piece of information or an initial impression. Women may be more susceptible to this bias if they are unfamiliar with investing and rely on a single source of advice, or a limited number of past experiences. One common anchoring bias example we see is individuals who inherit a single stock that they would never buy, but refuse to sell it to sentiment. Anchoring can lead to missed opportunities and poor decision-making.
Confirmation Bias: Confirmation bias is when we seek out information that confirms our existing beliefs or biases. There’s no shortage of information online, and it’s easy to fall into echo chambers of information that reinforce our existing belief structure. However, seeking out only confirming information can lead to poor decision-making and missed opportunities.
Sunk Cost Fallacy: Sunk cost fallacy is the tendency to continue investing in a losing position because of the amount already invested. Investors often feel pressure to justify their previous investment decisions. There is something to be said about “buy and hold” investing, but there are times where it’s better to cut your losses and run. It’s important to be able to distinguish between the two, and being aware of this potential bias is a great place to start.
What do you do to manage behavioral finance biases like these? For starters, it's important to be aware of their existence and how they may affect your financial decision-making. Consider educating yourself about investing, seeking advice from experts, and being willing to learn from your mistakes (it’s okay to make them, and the best way to move past is to admit we made them to ourselves.) Additionally, try to stay objective and avoid making investment decisions based on emotions or popular trends. Regularly review your investments, seek out diverse (but reputable!) sources of information, and be open to adjusting your investment strategy as necessary. This proactive approach can help you make better financial decisions and achieve your long-term financial success.
