Do Your Biases Affect Your Results?

Christian

POSTED BY

Christian White

Financial Advisor

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Biases can both help and hinder. However, too much of any one thing can have a negative effect on your portfolio’s return. The key is understanding that biases exist, and on a personal level, trying to understand which of them, if any, are dragging down your long-term results. 

Behavioral finance, a sub-field of behavioral economics, proposes psychology-based theories to explain and understand why people make certain financial choices. Here are 3 biases that most commonly affect the investor decision-making process:

Recency bias is the phenomenon whereby a person most easily remembers something that has happened recently, compared to remembering something that may have occurred a while back. In portfolio management, this means that the most recent market event— positive or negative— has the largest impact on the financial decisions you are making right now. Investing is a long-term game where one can lose out on market performance if short-term thinking clouds long-term planning. This is the bias that keeps you from investing when prices are low. It is also the bias, or that little voice that says, “I am just going to wait until things get better before I invest more”.

Confirmation bias suggests that you seek out only information that confirms what you already believe to be true and ignore evidence that contradicts your beliefs. Most of us have a built-in tendency to search for and to assimilate information that confirms our beliefs and we can tend to ignore evidence that contradicts them. Conformist thinking taken to an extreme can deplete one’s ability to think independently and objectively, which is crucial in decision-making. This bias can hinder your ability to investigate more optimal options for your wealth accumulation plans.

Endowment bias, sometimes referred to as divestiture aversion, describes a circumstance in which an individual values something that they already own more than something that they do not yet own. The perceived greater value occurs merely because the individual possesses the object in question. This effect can cause one to hold an asset in their portfolio for too long.

By understanding the common behavioral mistakes investors make, a quality financial advisor will aim to help clients take the emotion out of investing by creating an investment plan customized to the individual. Here are 4 examples of strategies that help ensure that neither your biases nor your emotions are at the wheel of your financial plan:

Strategic Asset Allocation Plan:

Portfolio strategy that involves setting target allocations for various asset classes and rebalancing periodically.

Tactical Asset Allocation Plan:

An active management portfolio strategy that shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors.

Benchmarking & Clear Portfolio Evaluation Summaries:

The process of measuring the performance of an asset or portfolio against market indices to ensure its ability to produce optimal risk adjusted returns. The most important aspect of behavioral finance is peace of mind. Having a thorough understanding of your risk appetite, the purpose of each investment in your portfolio, and the implementation plan of your strategy allows you to feel much more confident about your investment plan and be less likely to make common behavioral mistakes. ■