Whether it be the unpredictable Colorado weather, or the heightened volatility we have experienced in the financial markets since the onset of the COVID-19 pandemic, behavioral decisions derived from constant changes and uncertainty can foster poor decisions. From an investment planning standpoint, behavioral finance represents the human element in investing.
Corporatefinanceinstitute.com defines behavioral finance as:
“the study of the influence of psychology on the behavior of investors or financial analysts. It also includes the subsequent effects on the markets. It focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases”.
Let us look at some of these biases. While each one may not apply to every investor, identifying some common behavioral financial biases may provide the ability to avoid more than a few financial pitfalls.
Loss Aversion: the idea that a loss impacts investor confidence more significantly than a gain of the same magnitude. This means investors are more willing to sell a position with a gain, rather than realizing a loss on an investment which has declined in value. Waiting for an investment to regain its initial purchase price can be detrimental to a portfolio since regaining the loss may never happen. Further, it may also create a missed opportunity since a reallocation of the asset might serve as a better option.
Fear of Regret: the regret an investor may feel when having missed other opportunities. Fear of regret can lead to an ill-fated decision for buying the latest “hottest” stock to chase returns and make up for previous loses. Additionally, there may be no clear investment strategy for reentering the markets after accepting the loss by selling into weakness. This anguish of taking ownership of realized losses can deter an investor from making rational decisions.
Overconfidence (Optimism Bias): investor behavior that is ego-centric resulting in bad decision making. Hubris can be created from a bull market in which an investor believes their success is the result of their own doing and not the overlying economic environment. This can yield undesirable outcomes as the business cycle transitions to a recessionary state and an overconfident behavior may lead to poor investment decisions. An excellent performance of their investments can be attributed to the overall market performance not the individual investment choices made by the investor.
Confirmation Bias: choosing to adopt information which supports only one perspective rather than searching for research that challenges the same. This bias can lead to discounting important information. Information that may add valuable insight. A different opinion that adds a note of caution as an investor moves to implement a particular investment strategy.
Hindsight Bias: believing that events in the past were much more likely to occur once they happened. Conversely, believing events that did not occur were much less likely to happen. Hindsight is 20/20.
It is important to understand how certain biases may impact an individual’s investing strategy and to also identify the best manner in minimizing the negative implications associated with possessing certain biases.
Working with a qualified financial planner/advisor is an excellent way to help reduce the impact of investment biases. By developing and implementing a disciplined investment strategy, an investor will gain a powerful tool to help eliminate the fear and greed so prevalent in the investing community.
Adhering to a set investment plan can help to mitigate the irrational behavior that can foster a ruinous decision-making process. As asset managers, The Normandy Group believes in long term, disciplined and diversified investment strategies.
Here at the Normandy Group we have learned that by adopting a long term, disciplined and diversified approach investors have the best potential to reach the financial goals for which they invest in the first place.
The CERTIFIED FINANCIAL PLANNER™ Professionals and Certified Estate Planners™ at The Normandy Group offer serious investment planning for today’s complex world. By combining investment, tax, and estate planning strategies we can help you achieve your goals. Contact us today for a complimentary consultation.