Investor heuristics and biases don’t often serve us when making complex financial decisions. Here’s how to recognize them and combat them.
In recent blog posts, I’ve talked about the benefits of being positively skeptical when consuming information and making important financial decisions. While it may be clear to most at this point that we as investors have a tendency to let emotions cloud our decision-making, you may still be wondering why. Why are we hardwired to make irrational decisions?
A Double-Edged Sword: The Good and Bad of Investor Heuristics
As humans, we’re forced to make thousands of decisions every day, from which foot to lead with when getting out of bed to what to make for dinner. If we had to think about every single decision we make on a daily basis, we’d be mentally exhausted before breakfast. Instead, we rely on heuristics—also known as mental shortcuts—to get through the day.
In this sense, heuristics can be very helpful. Having the ability to make quick decisions is what allows us to be productive members of society and solve larger, more important problems.
However, these mental shortcuts don’t always serve us when making complex decisions. Indeed, heuristics aren’t supposed to result in optimal decisions, but rather “good enough” decisions given a limited timeframe. That’s why it’s important to recognize them at play and keep them in check, especially when faced with information meant to appeal to our instincts, not our intellect.
Here Are 5 Investor Heuristics To Watch Out For (And The Simple Ways To Combat Them):
Heuristic #1: Confirmation Bias
Confirmation bias is the tendency to favor (and believe) information that confirms our preexisting beliefs. For example, the sources you get your news from are likely a reflection of your confirmation bias.
The problem with confirmation bias is that it can lead to blind spots in our thinking. In other words, by avoiding information that challenges our beliefs, we can prevent ourselves from making optimal decisions.
To combat confirmation bias, seek out news and information from a variety of sources—especially ones you wouldn’t normally consider. In other words, look for holes in your thinking. It may not be easy or comfortable to do this, but it will help you avoid blind spots when making important decisions.
Heuristic #2: Familiarity Bias
Simply put, familiarity bias is the tendency to prefer the familiar to the unknown. In investing, this can lead to a portfolio that’s heavily weighted towards U.S.-based blue-chip companies. Moreover, familiarity bias helps explain why 73 percent of corporate employees who participate in an equity plan also own additional shares in their company, mostly through their workplace retirement plan.
Ironically, just because something is familiar doesn’t mean we have a greater understanding of it. Indeed, the Enron Scandal is an extreme example of how investing in the familiar can lead to catastrophic outcomes. In addition, most of us don’t understand the inner-workings of Apple or Microsoft, even though we use their products every day.
To combat familiarity bias in investing, make sure your portfolio is well diversified among asset classes, investment styles, and geographies. If you’re not comfortable with selecting these investments for yourself, work with a financial professional, who can help you construct a portfolio that’s aligned with your risk tolerance and financial goals.
Heuristic #3: Self-Attribution Bias
As a successful business owner, you’ve obviously made some good decisions in your life. And we can all agree that watching an idea play out exactly how we envisioned it is rewarding and motivating. Still, how often do we acknowledge the decisions we’ve made that didn’t work out as planned?
Self-attribution bias is the tendency for investors (and business owners) to attribute good decisions to our own skills and knowledge and blame bad decisions on external factors. Unfortunately, by not critically evaluating our mistakes, we can become overconfident in our decision-making abilities.
It’s important to recognize the roles luck and chance play in every investment decision, because there are always factors outside of our control. To combat this heuristic, stick to a well-defined investment process that’s in line with your overall financial plan.
Heuristic #4: Anchoring Bias
Anchoring is the tendency to rely too heavily on one piece of information when making a decision. As such, anchoring tends to apply to numerical decisions. Usually, the final number in a negotiation tends to be close to the first number mentioned, regardless of its relevance.
For example, if you’re valuing your business, you’re likely to use the first valuation you get as the basis for evaluating subsequent valuations—even though the first one may not have been reliable. Similarly, investors tend to judge a stock’s value relative to its most recent price, not its future value, which can lead to poorly timed trades.
To avoid anchoring, be sure to evaluate data over a meaningful time frame. In addition, consider the future, not just the past, when making investment decisions.
Heuristic #5: Herd Mentality
Lastly, we are all susceptible to herd mentality, possibly more so now than ever before. Herd mentality explains our tendency to believe the consensus is right and follow the crowd without doing any independent research.
Herd behavior causes problems in investing because it can lead to market bubbles. More specifically, investors tend to pour their money into whatever area of the market is doing best, pushing prices up until they become unsustainable, and the bubble bursts. This is dangerous, because investors almost never recognize bubbles until it’s too late.
To avoid herd mentality and behavior, do your research. Don’t allow yourself to jump on the bandwagon, simply because you fear missing out on potential gains. Instead, make sure you have a sound basis for your investment decisions.
When All Else Fails, Stick To Your Plan
Though it may seem redundant, having a financial plan and sticking with it regardless of external forces is the best way to combat investor heuristics and biases. If you need a financial plan or want a professional financial planner to review yours, start by requesting a free retirement assessment. We’re here to help.