Behavioral finance biases can make or break your journey to building wealth.
The truth at the heart of behavioral finance is the fact that we are not rational decision-makers when it comes to our money.
The following five psychological and emotional aspects of an investor’s behavior have a huge impact on the investment decisions they make.
We also discussed several of these topics in episode 44 of our podcast titled “what behavioral economics means to you.”
- Results from good stock picking over a short time period.
- Can often lead to over trading
- JP Morgan-A Lesson in Overconfidence Bias
2. Familiarity Bias
- Investing primarily in their country of residence because it is familiar.
- This also includes investing a large portion of your portfolio in the company that you work for. Having a high percentage of your assets as well as your income in your company heightens your risk and offers little diversification if your company experiences a time of financial difficulty.
- Familiarity Bias Thwarting Wall Street Employees, Are You Next?
3. Hindsight Bias
- Investor believes they predicted a particular past event, which in fact they did not
- This leads to overconfidence and the investor thinking they can predict future events.
- Picking a fund based on how it has performed lately or fear of missing out on future gains.
4. Naive Diversification
- Investing in every option available to the investor in their 401k plan.
- Using a large number of fund choices so you “feel” more diversified.
5. Confirmation Bias
- The act of seeking out information that reaffirms beliefs about an outcome.
- Those seeking confirmation bias often ignore any contradictions to their beliefs.
- Example: Predicting the market will fall based on negative news, and only seeking out negative new to support that viewpoint and belief.
- Nowadays, we have so much information that anyone can find information to support their beliefs. This bias may lead you down the wrong path when dealing with your finances.
Behavioral Finance Matters
Many of these types of behavioral finance are common for investors and can often lead to under performing investment results. One way not to fall victim to these behavioral pitfalls is to avoid the emotional investment decisions by outsourcing these decisions and have your assets professionally managed by a financial advisor. Take a look at our investment strategy to see how a disciplined investment approach can help you stick with your plan in the most volatile times.
Outline of This Episode
- [1:21] Overconfidence
- [6:27] The familiarity bias
- [11:25] Hindsight bias
- [16:14] Naive diversification
- [21:15] Confirmation bias
Resources & People Mentioned
- BOOK – Thinking Fast and Slow by Daniel Kahneman
- Episode 177 – 10 Investing Principles: The Fundamentals That Guide Your Investing Decisions
- CNBC – Overconfidence may be getting in the way of your investment performance.