It may look like a numbers game, but investing is really all about people. It is crucial to identify your unique traits and desires, and tailor your financial goals accordingly. It is also crucial to understand how you will reach those goals, and how you might get in the way of achieving them. In the next few posts on this blog, I will walk you through eight biases that often interfere with a sound investment strategy. Certain psychological tendencies can sabotage our best efforts to grow wealth, so acknowledging and taking steps to mitigate them is key to long-term success. We help all our clients develop financial goals and remove the obstacles to those goals.
You’re sitting around the dinner table at Thanksgiving, and, despite your best attempts, the conversation turns to politics. You end up discussing a sensitive topic with your great uncle Marvin, and you discover that he strongly believes in something you know to be false. You present him with facts, but he finds ways to discount or explain away everything you say. What gives? Great uncle Marvin is probably succumbing to what’s called “confirmation bias” – an information processing bias that most of us fall victim to without even realizing it. Confirmation bias means that we pay more attention to information that supports what we believe in while ignoring the rest. When we are presented with something new, we often resort to our preconceived opinions instead of investigating or incorporating the new information into our worldview.
A corollary to Confirmation Bias is Anchoring Bias, which describes our tendency to rely on the first piece of information we are given to make our future decisions, even when that piece of information has no relevance to the issue at hand. For example, if you inherit your grandmother’s treasured soup terrine and Great Uncle Marvin tells you it’s worth $500, when you list it for sale, the price you choose to list it at will be around $500, and, even if your Google searches reveal it’s worth $250, you feel like it’s worth more. Studies have demonstrated that anchoring bias exists even when numbers are unrelated to the task at hand. In one instance, researchers showed participants a number based on each participant’s phone number, and asked them “What year was Attila the Hun defeated in Europe?” The random number affected how participants answered the question.[1]
Confirmation Bias and Anchoring Bias can have a negative impact on investment decisions. When we fail to incorporate new information about investments – such as a change in technology that will probably result in a decrease in value in a stock – or new information about our own financial needs – not getting a raise you were expecting, for example – we fail to change our investment strategy, and therefore miss out on increased returns or suffer losses. Similarly, when we get too attached to a certain number, such as the price for which we initially purchased a security, we fail to make changes when they need to be made, and often suffer.
There are several ways to mitigate these biases. First, acknowledge that they exist and questions yourself whenever you feel uncomfortable about change or attached to your current holdings. Next, set your own anchors based on objective information (like historical trends) and personal decisions (like retirement date and loss tolerance). Finally, put neutral resources to work on your behalf. Finding an advisor who can help you recognize your biases allows you to overcome them.
[1] “Incorporating the Irrelevant: Anchors in Judgments of Belief and Value,” Heuristics and biases: The psychology of intuitive thought, New York: Cambridge University Press, 2002.