Whether you’re new to investing or have developed a robust portfolio, you are not immune to the subtle, often unconscious forces that shape human behavior. These emotional and cognitive shortcuts, known as behavioral biases, can have a powerful impact on how you make investment decisions and manage your wealth. Recognizing and addressing these biases is essential for making sound investment decisions and pursuing your financial goals.

The role of emotions and biases in investment choices

You may assume that greater wealth or access to resources naturally leads to better decision-making. In reality, the pressure to preserve capital, sustain a legacy and outperform benchmarks can heighten your emotional responses. Market volatility, headline-driven news cycles and comparison with peers can create conditions ripe for impulsive choices.

Emotions like fear and greed can distort your risk perception, while personal success in other areas of your life may fuel overconfidence in investing. Moreover, wealth can sometimes insulate you from the full impact of poor decisions, allowing your biases to persist unnoticed. To protect your financial health, it’s vital to understand the types of behavioral biases that may be influencing your portfolio choices.

Five common and harmful investment biases

Here are five of the biases that turn up most often:

  1. 01

    Overconfidence bias

    This occurs when you overestimate your knowledge, skill or ability to predict market movements. If you’ve had success in business or other areas of life, you may assume your judgment will translate seamlessly to investing. Overconfidence can lead to excessive trading of one’s investments, failing to stay invested for the long-term and triggering additional taxes and transactional costs.Ìý

  2. 02

    Loss aversion

    Research has shown that we feel the pain of losses about twice as acutely as the pleasure of equivalent gains. This bias, known as loss aversion, can lead you to hold onto underperforming assets too long or make it difficult to take strategic risks.

  3. 03

    Herd mentality

    Following the actions of others—whether peers, analysts, or media figures—can result in buying high and selling low. In times of market stress or high performance, herd behavior can lead you to make poor investment decisions.

  4. 04

    Confirmation bias

    Do you seek out information that supports your existing beliefs while ignoring evidence that contradicts them? Confirmation bias reinforces flawed assumptions and can lead to unbalanced portfolios.

  5. 05

    Recency bias

    This bias leads you to give undue weight to recent market performance, on the assumption that current trends will persist. A strong market rally or a sharp downturn can distort your expectations and lead you to chase performance (buying high and selling low).

Tactics to defend against behavioral biases

Combating behavioral biases requires structure, objectivity and professional support. These tactics can help you make more disciplined and rational decisions:

  • Work with a financial advisor. A trusted advisor can act as a behavioral coach, helping you step back, evaluate decisions objectively and stay focused on your long-term goals. Advisors also bring third-party perspective and can challenge assumptions influenced by bias.
  • Make a plan. Creating a strategic asset allocation plan can prevent emotionally driven decisions down the line. A rules-based framework encourages consistency, especially during turbulent markets.
  • Extend your time horizon. Most market volatility, such as bear markets (i.e. greater-than-20% declines in the S&P 500) is primarily a concern over short time horizons. If you have spending needs in the next 3-5 years, you may be able to protect yourself against bear market risk by earmarking safe assets for those expenses, while investing the rest of your wealth—earmarked for long-term goals—in a portfolio invested for long-term growth potential.
  • Use data-driven decision-making. Once you’ve worked with your advisor to create a plan, you can further ground your investment decisions by incorporating research, historical performance analysis and quantitative tools. Reviewing metrics, such as risk-adjusted returns and scenario modeling, can add clarity to complex choices.

Staying alert to tendencies that go against your goals

To stay focused on reaching your financial goals, it’s important for you to navigate the human tendencies that affect financial judgment. By working with a financial advisor to recognize these biases and proactively address them, you can protect your wealth and make better decisions no matter how the markets are trending.Ìý

At a glance

  • As your investments grow, you may become especially prone to emotion-based decision-making.
  • Behavioral biases, like overconfidence bias, loss aversion and herd mentality, can lead you to make poor portfolio choices.
  • Working with a financial advisor who employs data-driven decision-making can help you avoid falling prey to these biases.

Work with an advisor that can help you achieve your long-term goals.

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The information contained in this newsletter is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Investing involves risks, and there is always the potential of losing money when you invest.ÌýThe views expressed herein are those of the author and may not necessarily reflect the views of ÃÛ¶¹ÊÓƵ Financial Services Inc.Ìý

Neither ÃÛ¶¹ÊÓƵ Financial Services Inc. nor its employees (including its financial advisors) provide tax or legal advice. You should consult with your legal counsel and/or your accountant or tax professional regarding the legal or tax implications of a particular suggestion, strategy or investment, including any estate planning strategies, before you invest or implement.