Investors need to know their biases.
Everyone has blind spots in their lives -- with their money. While some of these biases don't have a huge impact on our day-to-day interactions or cause big problems with finances, there are times that certain propensities can actually be harmful in the long run. Here are seven behavioral biases that could potentially have a negative impact on your portfolio.
This bias occurs when you rely heavily on the first piece of information you get about an investment. You've anchored your beliefs about an investment to what you think is its worth or potential -- and it's hard to let go of that. As long as you act on that first bit of information, rather than taking into account new realities, you could wind up making poor decisions based on outdated facts.
When you fall prey to this behavioral bias, you seek out only information that supports your perception. So, if you see something that contradicts your supposition, or your belief about an investment, you immediately disregard it while cherry-picking what supports your belief. This can be especially dangerous when combined with anchoring, because you might be searching only for information to hold up your anchored belief -- and make poor investing decisions as a result.
The saying goes, "hindsight is 20/20," and nowhere is this truer than with investing. Looking back, it's easy to see the signs that pointed to a certain outcome. Rather than acknowledging that they might know everything or missed something, people like to pretend that they would have seen the signs because of their obviousness. Then, they look for the same signs in the future -- even though there's no way to completely predict what's next. They take historical data and try to apply it to the future, potentially making devastating decisions as a result.
People like the comforting and familiar. Sometimes that means investors don't take some of the small, calculated risks that are needed to create a successful portfolio. Other times, they stick with an investment, refusing to sell long after the fundamentals have changed. That familiarity can cause problems down the road. Related to this problem is the sunk-cost fallacy. You feel like you've put too much into an asset already and you're reluctant to cut bait and move on. If you stick with something that is dragging you down, it could negatively impact your portfolio in the long run, when you'd have been better off accepting the loss, deducting it on your taxes and moving on to something better.
One of the biggest biases is self-attribution -- the idea that they're geniuses when things go right. The market is rising and the portfolio is doing well, and investors figure it's all to their own efforts and smart trading. On the other hand, when things go poorly, people tend to attribute that to external factors. Generally, folks like to take credit for the good and blame others for the bad. When that happens, they're blind to their own mistakes and become overconfident. Once that overconfidence sets in, it's easy to think you have all the answers and make poor decisions, sure that it has to work out. When it doesn't work out, your portfolio could suffer.
The biggest issue associated with loss aversion is the concern that you'll lose out. So, rather than taking a calculated risk, you avoid most risk. When this happens, you actually do lose out. If you get so worried about stocks that you overweight your portfolio with assets that have lower returns, you end up missing out on a lot of potential gains down the road.
Many tend to think that things that are happening now will keep on in the same vein. This also manifests as a bias toward trends. Recent trends are projected into the future, when there's a good chance that things could change -- and change quickly. Getting too caught up in recent trends and failing to take heed of potential warnings, or even acknowledging that the trend just might not continue, can lead you to make changes to your portfolio that aren't in line with your long-term plan.
How to overcome your behavioral biases.
When overcoming a bias, the first step is acknowledging the issue. At its core, investing is about self-awareness. Understanding who you are, your goals and your weaknesses are all important if you want to be successful as an investor. Take an honest look at yourself and your biases. Then, take steps to protect yourself. Consider putting together a plan (with the help of a professional) for your investments. Avoid heading off course. Once you have a handle on your potential weaknesses, you're far more likely to adjust for them -- and your portfolio will be the better for it.
Investing blind spots that can hurt your portfolio:
-- Confirmation bias.
-- Loss aversion.
-- Recency bias.
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