3 Biases That Prevent Good Investment DecisionsMay 06, 2023
Over the past week, I've been meeting and helping many new clients through my "Maximize Your Wealth Potential" sessions. During these times, I guide them in identifying their life goals and finding ways to reach them faster.
In this process, I’m reminded that each and every one of us will have biases in decision-making. Normally, they are harmless, but sometimes they can hinder us from making good investment decisions.
That's why, for this week’s article, I wanted to share the most common investing biases and how you can overcome them.
#1: Loss Aversion
The psychological effect of pain from losing is almost twice as impactful as the joy from gaining. It’s why loss aversion is the human tendency to prefer avoiding a loss over making a gain.
To illustrate this, let’s say Harry has a lot of items in his house, and the lack of space is causing him stress. But he avoids letting go of these things because either they have sentimental value or he’s thinking that he’ll use them in the future.
What Harry doesn’t realize is that when he donates his belongings or even sells them to others, he’ll not just have more space; he'll even get to help people in need or earn some money on the side.
Similarly, in investing, a 10-20% unrealized decrease in the value of a fund can cause fear and prompt people to sell off their investments, even if they're intended for the long term. This bias then makes them forget and lose sight of the target, which is normally substantial gains over the next 5 to 10 years.
#2: Availability Bias
This is the tendency to overestimate the possibility of an event happening just because it easily comes to mind. This can result in decisions that are not based on accurate information.
An example is when we hear news of a plane crash. If you’re planning to go on a trip, you’ll definitely avoid booking a flight with the airline of the plane that crashed, or you might even avoid riding a plane at all.
But when we review statistics… the odds of being in an accident during a flight are one in 1.2 million, and the chances of that accident being fatal are one in 11 million. Conversely, the chances of dying in a car crash are one in 5,000. So traveling by air is much safer than by land. But we overlook this just because of the recent news of a plane crash.
In investing, this bias happens whenever there’s a new investment available in the market. Since it’s the talk on social media, people will look into it more and may even invest in it (or avoid it if the news surrounding it is bad). This can cause them to disregard other established investments with a proven track record.
#3: Confirmation Bias
This refers to the tendency to seek and interpret information in a way that supports your existing beliefs. This can lead to a narrow view of the world and a lack of consideration for alternative perspectives.
For example, let’s pretend we have a friend who is a huge F1 fan and has supported the driver “Max” ever since. He closely follows everything about Max, including Max’s life beyond the race track. For this pretend friend, Max is the best thing that ever happened to F1, he’s that big and loyal of a fan.
Whenever his favorite Max wins a race, he’s happy to say, “I knew it! He’s really the best.” But, when there’s negative news about Max not being a team player, this loyal friend will be quick to brush it off and immediately find a reasonable explanation for it to defend his idea that “Max is the best.”
Now, in investing, confirmation bias can make us feel like we’re being logical with our investments, even if we aren’t. Because if we initially like the idea of an investment, we look for more reasons to like it. However, if we don’t like a certain investment, then we look for more reasons to avoid it.
This makes confirmation bias the most dangerous of all. It is because we gather data (and so we think we’re being logical) when actually our data gathering is already driven by emotions.
As a result, confirmation bias can make us choose investments that aren’t a good fit for us and, at the same time, make us stick to inappropriate investments even when the logical thing to do is to let it go.
Two Simple Ways to Avoid Biases
Since we’ve now tackled the 3 most common biases in investing that can hinder us, let’s talk about solutions. Considering that we are all humans, and can be affected by these biases, there are really just two ways to avoid them:
Solution #1: Have a decision-making process.
First, having your own process requires you to think about how you’re making decisions. By stepping away from the decision at hand, you’ll be in a much better position to evaluate if you’re choosing correctly.
For example, here’s a simple decision-making process for whether or not to invest in something:
1. Do I understand the investment and how it works?
2. Is it aligned with my long-term financial goals?
3. Can I afford it if it doesn’t work out?
If the answer to all is YES, then that’s the only time I’ll invest. Otherwise, the answer is not now.
For some people, this solution might be too time-consuming. This brings us to the next option.
Solution #2: Consult others.
By consulting other people, you'll be able to get the perspective of someone other than yourself. This process of talking with another person alone already helps ensure you’re making the right decision.
Of course, the best people to consult are those who: (1) are experts in their field, so you are working with correct and accurate information, and (2) have your best interests at heart.
Do take note that sometimes this may not be the same person. This is why some people would opt to consult a financial advisor (the expert) together with a good friend or their spouse (for their best interests).
If you already have a financial advisor who you can fully trust, then consult them regularly so you know you're on track with your financial goals while avoiding these biases.
And that's it for the three biases that prevent good investment decisions and the two simple solutions to avoid them.
P.S. On the off chance that you still don't have a holistic financial planner and advisor, then I'd like to try out for the role! (I openly say this because even if I have two decades of experience in investment advisory, I know that trust always takes time to build.)
That's why, if you're looking for someone to help you with your financial decisions, I'd like to invite you to a free “Maximize Your Wealth Potential” session here.
In 30-45 minutes, via virtual meeting, we'll get to know each other, and in the process, you'll:
- Get clarity on your most important life goals.
- Optimize your finances to reach your goals faster.
- Decide on the next best steps to increase your income, savings, and investments while reducing risks and liabilities.
Overall, you'll leave the session feeling more energized and confident about your financial future.