Key takeaways
Behavioral finance is the science of why and how people make financial decisions.
There are three common behavioral finance biases that can affect investing decisions: cognitive, emotional and social.
Being aware of your biases is the first step. A financial advisor can also help bring a fresh, objective perspective to your investing decisions.
When it comes to investing, you like to think you’re a rational human being, making level-headed decisions that are in your best interest. The problem is that investing is a challenging activity, and sometimes your brain gets in the way.
Market changes and economic uncertainties can trigger emotions and knee-jerk reactions that derail your best-laid plans. Unfortunately, it’s all part of being human. Understanding the “why” behind these tendencies—a practice known as behavioral finance—can help you to address them.
During the 1970s, psychologists Daniel Kahneman and Amos Tversky studied what they called behavioral finance, which merges psychology and finance to understand why and how people make financial decisions. Their research found that most people are subject to unconscious cognitive biases that cloud their judgment and drive irrational choices.
“Kahneman and Tversky discovered that the human mind has two general decision-making responses,” says Eric Freedman, chief investment officer at U.S. Bank. “The first is fast response, where the mind makes a quick decision by going to information that is readily available. The second is the slow decision, which involves thoughtful cognition. With investing, the fast response and the slow decision are in complete conflict.”
Biases can affect investing in a variety of ways, and investors often don’t realize they’re at work. Awareness of these common biases can help you shift your mindset to make better decisions in the moment.
Cognitive biases happen when the brain’s ability to think and reason don’t comply with the principles of logic. There are two types of cognitive bias that are of particular relevance to investing.
Investing is often emotional, as it’s tied to dreams and plans for the future. Unfortunately, emotions can also create biases that lead to financial errors. Let’s review two types of emotional biases that can occur when investing.
The final type of bias that affects financial behaviors is social bias. This is when we act or reach decisions in response to the people around us. One type of social bias to remember when investing is groupthink.
“What happens with groupthink is that people default to either the most senior person or the person who talks the most,” says Freedman. “That's not always the best way to make decisions.”
“All investors have tendencies to make decisions based on emotion. Awareness is key, and putting sound practices in place is essential.”
Eric Freedman, chief investment officer, U.S. Bank
Groupthink can affect your investing if you talk with friends and family about your stock picks, for example. Their input can influence your behavior. Watching financial news shows on television can be another form of groupthink. It can be tempting to follow the advice of investing “experts” without doing your own due diligence and investing based on what’s right for your investing horizon and risk tolerance.
Instead of falling for biases that could lead to poor decisions, Freedman suggests adopting strategies that can help you determine whether facts or behavioral finance biases are informing your thinking.
Start by asking yourself, “Am I making a decision when my emotional state is amplified?” People often make an adverse decision during a times of heightened stress, such as bereavement, a job change or a big geographical move.
It’s also important to consider your time horizon. “In the diversified portfolio, not everything will be working at the same time,” says Freedman. “Investors sometimes respond emotionally to an unrealized loss, wanting to get it off their screen. This can drive a behavioral response.”
Keep yourself from checking your statements or account balances all the time, which can trigger biases and drive bad decision making. Instead, have a plan that’s in sync with your time horizon and your risk tolerance.
Working with a financial advisor and developing a comprehensive financial plan can help you manage your potential behavioral finance biases. For example, a plan can remove availability and groupthink biases by keeping you focused on long-term goals instead of reacting to current market events or making changes to your portfolio based on a layman’s opinion.
A trusted advisor working alongside you to create a plan also removes confirmation bias and anticipated regret by tapping into an educated and objective perspective that broadens your knowledge base. And advisors can help investors avoid loss aversion by helping them time entrances and exits from the market based on goals instead of volatility.
Remember, investing can be challenging, but it isn't a fight-or-flight activity. “All investors have tendencies to make decisions based on emotion,” says Freedman. “Awareness is key, and putting sound practices in place is essential.”
Learn how our team-based planning approach can help you review your investment and financial opportunities from all perspectives.
Instead of trying to time the market, consider buying stocks and other securities and holding on to them regardless of changes in the market. Read more about the benefits of this long-term investment strategy.
Let us help you craft a portfolio that reflects your goals, time-horizon and values.