Financial Planning

8 Behavioral Biases to Avoid

8 Behavioral Biases to Avoid
Improving your financial picture starts with self awareness

Consider this: The S&P 500 Index (SPX) has averaged an 8.2 percent annual return since 1996. During that same time period, however, the average investor has earned an annual portfolio return of just 2.1 percent.1 So while a hypothetical $1 million portfolio that tracked the SPX exactly would be worth nearly five times more today ($4.8 million) than 20 years ago, the average investor’s portfolio has barely grown by half ($1.5 million) its original value.

Much of this underperformance could be due to behavioral tendencies that lead to poor decisions about finances and investing. Understanding these biases will help you avoid common pitfalls and remain on track for your long-term financial goals.

8 biases to avoid

  1. Status quo bias: Preferring familiarity to the unknown. When investors stay on the sidelines in anticipation of geopolitical incidents, for example, they may be prevented from making a sound investment decision. But keeping your assets in cash doesn't mean you aren't making an investment decision, it means you're choosing to sacrifice long-term returns for short-term comfort.

    Telltale signs:

    · You rarely adjust your 401(k) holdings or contributions

    · You keep hanging on to underperforming investments

  2. Loss aversion: Intensifying the pain associated with losses and minimizing the joy associated with gains. For example, loss aversion is the driving force that causes individuals to spend hours looking for a lost $20 bill, compared to the moment of joy experienced when a $20 bill is found walking down the street.

    Telltale signs:

    · You err on the side of caution

    · You miss potential long-term opportunities due to fear of short-term losses

  3. Present bias: Placing significantly greater value on something received now versus something received in the future. Think of how purchasing an item now, such as a new car, feels a lot better than investing that money in your future. Acquiring items usually results in immediate gratification, whereas rewards for investing are generally reaped in the future.

    Telltale signs:

    · You delay saving for the future

    · You take on debt to finance current needs

  4. Recency/availability bias: Putting greater weight on recent events over long-term trends, especially if the event was emotionally impactful. In 2010, for instance—when the memory of the market's 37-percent drop in average return during the 2008 economic crisis was still top of mind—Franklin Templeton surveyed investors to gauge their impression as to whether the market was down, flat, or up in 2009. Despite the fact that the Dow rose nearly 23 percent that year, two-thirds of investors assumed that the market was either down or flat.2

    Telltale signs:

    · You immediately sell out of the market after a steep drop

    · You wait to get back into the market until it is near a peak

  5. Confirmation bias: Bringing all positive indicators to the forefront, while allowing potential concerns to recede into the background. For example, an investor might hear about a stock that is doing well, so he or she does their research to prove its potential is real—their eyes are open to the green flags, such as growing cash flow but closed to the red, such as dwindling markets.

    Telltale signs:

    · You develop a positive feeling about a certain stock/sector and subconsciously seek out information that supports this opinion

  6. Clue-seeking bias: Using irrational reasoning when trying to make rational decisions, especially when the decisions are complex. A 401(k) investor who chooses the first mutual fund on a provided list assuming it must be recommended because of its placement, for example.

    Telltale signs:

    · You are drawn to an investing choice due to its name, its placement on a list or another immaterial quality

  7. Optimism/overconfidence bias: Estimating higher-than-average odds of good results. For example, if you were to ask a room full of investors to rate their skills as below-average, average or above-average, chances are roughly 90 percent would say average or above-average.

    Telltale signs:

    · You are hesitant to set up contingency plans for long-term care or other future challenges

  8. Herding bias: Following the herd, even when the herd may be acting counter to an individual's best interests. Every time there is a new investment trend or hot stock, financial professionals may feel pressured to follow the masses. And it's easy to see the temptation; if it works out, everyone is happy. If it doesn't work out … well, it's justified, because everyone was in it together.

    Telltale signs:

    · You occasionally buy high and sell low along with the crowd, despite your own research and intuition

Strategies for overcoming biases

  1. Make a conscious effort to gather empirical data to balance intuition and instinct, and actively seek out any and all evidence that stands counter to your basic assumptions
  2. Learn from your failures so you understand how to avoid them in the future
  3. At all costs, avoid financial information overload, which can cause you to second-guess your instincts
  4. Ask your advisor to work with you to help you conquer these biases and determine short- and long-term financial goals

"People who are right most of the time are people who change their minds often."

—Jeff Bezos, CEO and founder of Amazon.com

1 "Investing and Emotions," 2016, BlackRock

2 "MAJORITY OF AMERICANS HAVE MISPERCEPTIONS OF STOCK MARKET PERFORMANCE," Sept. 24, 2012, Franklin Templeton Investments

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