The Psychology of Investing

What is financial bias?  

Human beings are not always rational. Most decisions we make on a daily basis involve some sort of mental shortcut using decision making patterns. When it comes to important choices, a battle is waged between emotions and logic.. When it comes to financial decisions, our emotions can sometimes overrule sound investment decision-making, which we call financial bias. These biases can play a pivotal role in influencing individual and family welfare.

Let’s look at a simplified example:

Eisenberg wants to fill his car with gas. There are two options, a gas station by his house that sells fuel for $1.2/litre, and another gas station 10km away that sells for $1.15. Option two means Eisenberg will invest time and gas to drive to the station with cheaper fuel. In the end, is it really the cheaper option? Eisenberg’s decision in this example is based on cognitive bias, an intuitive and emotional decision that can trick us when making decisions. 

Research has shown that there is a correlation between high levels of some common biases and unfavorable financial outcomes. Below are some examples of most common financial biases. 

  • Present bias: Tendency to overvalue immediate smaller rewards at the expense of long-term goals.
  • Overconfidence: Tendency to overweight one’s own abilities or information when making an investment decision. 
  • Loss aversion: Tendency to be excessively fearful of experiencing losses relative to gains. We may all know someone who will watch one of their stock investments slowly lose value over time and can not stomach to sell it . . .a because then it’s a “real” loss not just a “paper” loss.
  • Anchoring: means a fixation, often unconsciously, on past reference points such as price paid or market high/low, instead of current and future price or value.
     

How can we prevent our biases from clouding our judgement? 

While we may not be able to eliminate our biases completely, there are things we can do to minimize their potential to negatively impact our financial life. For example, we can set up a uniform decision-making process before important choices. One such example would be to employ a 3-day waiting period before making major changes to our portfolio, so we do not  act on impulse.

Additionally, it’s best to ignore the daily noise. That is, avoid focusing on daily price updates of any stock or other investments, especially moment to moment and instead maintain a longer term view.

Standard finance approaches are typically based on assumption that investors are always rational, not subject to emotions and they make financial decisions to maximize their wealth for a given level of risk. At Wealth Stewards we understand the importance of behavioural finance. Our advisors employ innovative tools to help discover your financial biases and we work with you to create a solid portfolio management approach to help reach your financial goals. 

If you have not completed your financial behavior assessment, please reach out to your advisor to do so.