The investor’s chief problem – and even his worst enemy – is likely to be himself. - Benjamin Graham
Established economic and financial theory posits that we individuals are well-informed and consistent in our decision-making, that investors are ‘rational’ and when they receive new information, they update their beliefs immediately and correctly. In reality, humans often act irrationally – in counterproductive, systematic patterns. 80% of individual investors and 30% of institutional investors are more inertial than logical.
You may think that you simply need to gather more information in order to make better decisions. However, despite the abundance of information available, many people still make less-than-ideal financial decisions. This is where the field of behavioural finance comes in. This article explores the 3 common biases that lead to overconfidence in financial decision-making, leading to excessive risk-taking and lack of diversification.
With the economic uncertainty we’re facing, it’s never been more important to know how to make sound financial decisions.
What is behavioural finance?
Behavioural finance combines principles from psychology and economics to understand how the biases and emotions we have affect our financial decisions. By understanding the biases, we can learn strategies to overcome them to make good financial decisions that help us achieve our financial goals. The 3 common biases are availability bias, confirmation bias and short-termism.
The impact of the availability bias
You’re at the grocery store in the dairy aisle, browsing the endless range of cheeses, and you recognise a brand that you saw on a YouTube ad. Even though it’s twice the price, you’re more likely to buy it because it’s the most easily accessible information in your memory. This is an example of availability bias in action.
Availability bias is our tendency to rely on information that is most easily available in our memory, rather than putting in the effort to seek new information, like reading the labels, nutritional information and unit prices of the other cheeses.
This bias impacts our financial decision-making because it can lead to a skewed perception of the likelihood of certain events or outcomes.
For example, if we’ve recently read one positive news article about a certain stock or industry, that information may be more prominent in our minds, and we may be more likely to invest in it as a result. However, this can lead to a skewed perception of the stock’s performance, as the positive news is just one piece of information among many that affect its performance.
Similarly, availability bias can also cause us to overestimate the likelihood of negative events or outcomes. This can lead to excessive risk aversion and can cause us to miss out on potentially profitable investments.
The confirmation bias trap
Do you find yourself firmly believing that your sports team is the best even when they’ve racked up consecutive losses? When you read or hear news that contradicts your beliefs, do you automatically find a reason to discard it? That is your confirmation bias at work.
Confirmation bias is our tendency to seek out and give more weight to information that confirms our existing beliefs or biases, while discounting or ignoring information that contradicts them.
When it comes to our financial decision-making, confirmation bias can be positive or negative.
We can have a positive bias towards a particular stock because it’s performed well for us in the past. Consequently, we may seek out news articles or analyst reports that support our belief, overlooking important warning signs or red flags that may indicate a risky or unsustainable investment.
Similarly, if we have a negative bias towards a particular investment or strategy, we may be more likely to dismiss positive information and miss out on valuable opportunities.
Confirmation bias can also lead to the bandwagon effect (or groupthink), where members of a group — like your family, friendship group or workplace — reinforce each other’s beliefs and ignore dissenting opinions.
To minimise the risk of confirmation bias, we should attempt to challenge the status quo and seek information that causes us to question our investment thesis. It is much more important to ask yourself why you are wrong than why you are right. Charlie Munger, the Vice Chairman of Berkshire Hathaway and Warren Buffett’s business partner, said: “Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”
The price of short-termism
Short-term thinking is something we’re all probably more familiar with than we’d like to admit. In financial decision-making, short-termism is an excessive focus on short-term results, like quarterly earnings, at the expense of long-term interests, like strategy and long-term value creation.
Short-termism in everyday financial decision-making can look like accumulating credit card debt from buying things you can’t afford, taking out a loan with high interest rates to buy a new car and spending all your money on fun things today and not saving for emergencies or retirement.
When it comes to investing, it can be displayed as making impulsive and emotional short-term financial decisions, such as selling stocks during a market downturn in a panic. Or, short-termism can look like constantly chasing short-term returns and jumping from investment to investment, without considering the long-term impacts. The consequences include missing out on longer-term opportunities and a portfolio that isn’t well-diversified and able to weather market ups and downs over the long-term, leading to losses.
Strategies to avoid these 3 common biases in financial decision-making
You’ve already taken the first step by learning more and being aware about them!
Now, here are 5 more actionable steps to take:
- Don’t rely solely on one piece of information — do your research!
- In doing your research, seek out different sources (like a financial newspaper, an interview and a podcast) and different perspectives (like what different banks and funds are saying and even Reddit threads and YouTube videos)
- Back up what you find with data and statistics, rather than relying on opinion and anecdotal evidence
- Focus on your long-term financial goals and objectives and consider the potential long-term consequences of a decision
- Finally, seek input from trusted financial advisors or professionals.
The latter is especially important because overcoming biases requires discipline, time, and willingness. This is why having the support of a professional can have a huge impact on ensuring you make more informed decisions that are more likely to lead to long-term financial success. At Green Associates, we can assist you with financial advice, investment planning, retirement planning, and more. Book an appointment with a Green Associates Financial Planner and Adviser today to ensure you are making well-informed and objective decisions for your long-term financial health.
At Green Associates, all of our advisers are fully licensed and listed on the ASIC Moneysmart Financial Adviser Register. Green Associates is committed to providing the best solutions for you and your wealth-creation journey.