Avoiding Investment Bias

Research shows that humans generally form an optimum balance between risk and any benefit it might be associated with. Unfortunately, this scenario also applies to undesired social and cultural factors:

• Voluntary and involuntary risk. When weighing an activity, people generally accept greater voluntary risk. For example, research shows that people view an activity such as rock climbing as having less risk than the involuntary risk of drinking fluoridated water, though more people are affected by their drinking water than engage in rock climbing.
• Informed risk. People generally perceive risk levels in the current moment as higher than those already experienced. This explains why current topics like genetically modified food are ranked riskier than cleaning ears with a cotton swab, despite the greater risk for injury that cotton swabs pose.

Key Influencers in Our Understanding of Risk

The good news for avoiding investment bias is that investor risk tolerance can be measured. By studying a person’s willingness to engage in risky financial behavior, financial advisors can work to mitigate these factors.

Several heuristics can negatively affect an investor’s perception of risk and impact their best intentions. Key influencers include:

• Media Influence. Public awareness by the media can influence an investor’s perceptions depending upon the amount of coverage, how the message is framed, the tone of the message, the trustworthiness of media sources, and the format in which information is presented, and source channels.
• Availability heuristic.  Heuristics suggests that when people are aware of risks, they make assumptions that those risks occur more frequently than is reality.
• Affect heuristic. Relying upon current emotions to make decisions about risk.

Cognitive Biases

We have identified six main cognitive biases that can be harmful to investors. These detrimental biases can derail investors’ ability to make the best possible decisions about building their wealth. We examine them more closely:

Overconfidence. Investors may overestimate the confidence level and the accuracy of their judgment as greater than the objective accuracy of those judgments. In other words, the subjective estimation of our accuracy and reliability is greater than it objectively is. This bias can result in an investor that has an unrealistically positive view of performance and results. What to do – To overcome relying on confidence rather than data, it is important to ask if our judgment is based upon our level of knowledge, or if we have applied due diligence in research and fact-gathering.

Familiarity. Investors often make assumptions during the decision-making process based on patterns and outcomes previously observed. For example, we may select funds to invest in that are the most familiar or ones we recognize. This bias can result in an investor that is immobilized, despite the possible benefits that can come from diversification. What to do – To put this bias to rest, we must understand our need to seek out patterns where there are none and commit to remaining open-minded about things we may not have heard of before.

Information overload. When we are under stress or are being hit by too much information, we naturally adopt coping mechanisms. One of these mechanisms is to over-simplify the problem. But the less knowledge and understanding we have about our investments, the less well we cope. This bias can result in an investor that becomes paralyzed at the prospect of too many choices. What to do – To control our innate desire to over-simplify issues, we must tap into our patience and affirm to ourselves that we are not simply taking the easy way out rather than doing the work necessary to reap the benefits.

Anchoring. Once an option presents itself, we sometimes anchor ourselves to this original piece of information, failing to sufficiently consider the realm of other possibilities. This means we selectively filter out information, preferring to focus on data that supports our view. This bias can result in an investor that may only look at options that support their original view, rather than seek out information that informs other views. What to do – While it is important to recognize that historical data can provide us with great insight into current data, we must ensure we do not automatically adopt historical conclusions.

Herding. This bias takes place when rational people begin behaving irrationally, by limiting judgment based on what others are doing. We often look to others, including institutions, for affirmation and acceptance, allowing them to color our judgment. The same holds true as we gravitate to investments based upon what others are doing, or what we’ve heard. What to do – To stop ourselves from selectively seeking out the opinions of others in our judgments, we should avoid listening to the “noise” and instead, seek out verifiable data. By considering the alternatives, we can fully vet our judgments and help ensure they are not based solely upon what the group is doing.

Loss aversion. ur experience with loss means we rank them higher than other experiences. Applying prospect theory, our past losses feel worse to us than our past gains feel good.  Sometimes we make decisions based upon the fear of loss so as to avert its occurrence, instead of considering the benefit of potential gain. We may even go to illogical lengths to avoid the loss, which can negatively impact our desired outcome. What to do – To control our tendency to freeze, we should make sure our plans allow for wiggle-room and recognize that statistically, the odds of both loss and gain are equal in strength.

By understanding these six biases we hold the key to safeguarding the negative impact they can have on our decision-making process.

Hone Your Decision-Making Skills

It’s hard not to see ourselves as having sound decision-making skills, but our level of risk-taking can be directly related to that skill set.  Honing these skills can help investors make better choices. According to the University of Massachusetts Dartmouth, seven steps can be applied to help you with decision-making:

1. Identify the decision – are you certain your focus is the right one?
2. Gather facts and information – do your research
3. Brainstorm – gather your friends and family and toss around ideas
4. Identify alternative solutions – think about other paths to achieve your objective
5. Weigh all evidence collected – scientifically analyze the information
6. Choose among the alternatives – select from the alternatives you researched and weighed
7. Take direct action – implement the alternative you selected
8. Review the decision and consequences – if the result is not what you hoped for, review the steps again

Adopt New Investing Strategies

When it comes to investment risk, perhaps the best option for most people is to think of it in terms of balance. As investors, we should strive not to control fear, which can overinflate the possibility of failure. Conversely, we should limit our inner Superman in underestimating what could go wrong. Both tendencies have a limiting effect and can immobilize us in making decisions.

Several things can help set apart successful investors from average investors. Generally, they:

• Actively help plan a portfolio that protects and grows for the future
• Routinely review and monitor portfolio strategies
• Try to organize your financial life to see where you are in meeting your goals
• Use an online risk assessment tool that helps you understand your tolerance for risk
• Download a financial planning app to help you keep track of your portfolio, in real-time
• Begin a “news diet” and dial down the television, radio, and online news for a while

Let us know if we can answer any questions you might have.  You can reach us at one of our convenient offices listed on the Contact Us page or by filling out the chat form below.