You Don’t Own Me — Behavioral Bias in Financial Decision-Making

November 16, 2020
By Rick Gibson, CFP®

My wife and I recently had a debate about what we were going to order for dinner. We decided to order Indian food from across the street, because we agreed that it is the best Indian food in the area. Or is it? The truth is, we are biased because of the good reviews and our most recent dining experience. Now, there really is not much harm in being biased when it comes to choosing a restaurant, but what about more important financial decisions?

I cannot tell you how many times I have heard, “I think I should invest in _____, because the price just keeps going up and everyone says to buy it now.” But is everyone really buying the stock, and is there really evidence that the price will continue to go up? Or do people only think that because more than one person mentioned the stock, or it was on the news. Every stock pick has the potential to be brilliant, until it isn’t. Before jumping on any financial-related bandwagon, take a step back, and ask yourself what biases may be influencing your decision-making process.

There certainly are plenty of biases to choose from; overconfidence, recency, loss aversion, confirmation, herd following, and the list goes on. Recency bias occurs when someone focuses too much on recent events, and loses sight of the big picture. For example, thinking that a certain sector will continue to climb in value because it has over the last few years, is a form of recency bias. Overconfidence bias occurs when someone over values their own ability or skills. Anyone who has ever made a good stock pick has, at that time, believed that they have superior stock picking skills to the professionals.

Here is an example that might resonate. I have a friend who decided to invest in a few stocks in March. First thing to note is that he was fortunate enough to invest his money near the market bottom. Second, the stocks he selected have since performed absurdly well. This combination of fortuitous timing and beginner’s luck creates overconfidence bias. Investing must be easy, right? I wish…there is actually a lot more that goes into building a portfolio than specific stock selection, no matter how successful the pick. But it is difficult to preach dollar cost averaging, or the benefits of a diversified portfolio, when it appears as though a few good stock picks can solidify our long-term wealth. We all have our biases, which can ultimately impact our financial future. 

The first step in overcoming any bias is to acknowledge where you may have blind spots, and start thinking about your short and long-term goals. When investing, or really considering any financial decision, it is imperative to establish goals early on and not lose sight of the big picture. These goals should be SMART: specific, measurable, attainable, realistic, and timely. And as you set goals, keep asking yourself, “Are these really my goals, and why?” Having well thought out goals will help you avoid making hasty investment decisions based on daily market fluctuations. Your goals will also allow you to really picture retirement, and whether you are ready now, or can wait until later. Think of your goals as a roadmap that will take you where you want to go. At the same time, understand that goal setting is not immutable. You are allowed to change your goals, based on new evidence, circumstances, or a better understanding of yourself. 

One of the (unsung) benefits of a financial advisor is that we tend to check our biases at the door, when it comes to our clients. At WFS, the investment committee meets weekly to discuss current market conditions and which investments make the most sense in light of these conditions. Without the collaboration of a committee, it might be difficult to provide un-biased recommendations. The same collaborative approach is how we approach our financial planning. We have a different perspective that allows us to identify your biases and work with you to meet your goals. It is important to discuss everything openly and honestly — even when it’s not easy or comfortable. If you would like to learn more about different biases or have questions about how to start investing, or how financial planning can benefit you, give us a call. You will be glad you did. But, I could be biased.
 

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Important Disclosures

  • West Financial Services, Inc. (“WFS”) offers investment advisory services and is registered with the U.S. Securities and Exchange Commission (“SEC”). SEC registration does not constitute an endorsement of the firm by the SEC nor does it indicate that the firm has attained a particular level of skill or ability. You should carefully read and review all information provided by WFS, including Form ADV Part 1A, Part 2A brochure and all supplements, and Form CRS.

  • This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept. These materials are not intended as any form of substitute for individualized investment advice.