Behavioral Financial Bias

March 21, 2023

How to recognize and overcome bias in financial decision making.

Behavioral financial biases are a fascinating and complex topic that can have a significant impact on our financial decision-making. These biases are essentially psychological tendencies that influence the way we perceive and evaluate financial information, leading us to make decisions that may not be rational or optimal. By recognizing our biases, we are able to improve our decision-making ability with regard to our finances.

One of the most common behavioral biases is the anchoring bias. This occurs when we rely too heavily on the first piece of information we receive when deciding, even if that information is irrelevant or inaccurate. For example, if you see a stock's price at $100, you might anchor on that price and find it difficult to adjust your valuation even if new information suggests that the stock is now worth significantly more or less. This is a short cut in our decision-making process when we are unsure of value. We tend to “anchor” ourselves to the first known price. This is why sales are so effective, they anchor you to an original price and emphasize the discounted amount. People then tend to look at the discount as opposed to the intrinsic value of the item.

Another common bias is confirmation bias. This occurs when we actively seek out information that confirms our existing beliefs and ignore information that contradicts them. For example, if you strongly believe that a particular stock is undervalued, you might only seek out information that supports that belief, while ignoring any negative news or analysis. With a variety of different sources available through the internet it is easy to seek out opinions that reaffirm our own this is why it is important to find different opinions and evaluate your decision making on the merits.

Overconfidence bias is another common bias that can lead to poor financial decisions. This bias occurs when we overestimate our ability to predict the future or our own skill at investing. This can lead us to take on excessive risk or make overly aggressive investments. A certain amount of hubris is necessary in investment, so it is important to have conviction in your decision but at the same time evaluate the probabilities and effects of being incorrect.

Loss aversion is a bias that can cause us to be overly cautious with our investments. This bias occurs when we feel the pain of losses more acutely than the pleasure of gains, causing us to avoid taking risks that could lead to losses even if the potential gains are significant.

One of the most insidious biases is the sunk cost fallacy. This bias occurs when we continue to invest in a project or investment that is no longer viable simply because we have already invested significant time, money, or effort into it. This bias can lead us to continue investing in losing investments, even when it would be more rational to cut our losses and move on.

Behavioral biases can be challenging to overcome, but there are some strategies that can help. One approach is to seek out diverse perspectives and opinions to counteract our natural confirmation bias. It can also be helpful to take a step back and examine our emotions when making financial decisions. If we are feeling overly confident or fearful, it might be a sign that we are under the influence of a bias.

Another strategy is to use rules-based or systematic approaches to decision-making, which can help remove some of the emotional biases that can cloud our judgment. Finally, seeking the guidance of a financial advisor can help us identify and overcome these biases and make better financial decisions over the long term.

In conclusion, behavioral biases are a fascinating and complex topic that can have a significant impact on our financial decision-making. By understanding these biases and developing strategies to overcome them, we can make better decisions and pursue our financial goals.

The opinions expressed in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

About the Author:

Kevin W. Meyer is a Financial Advisor at John Bailey Financial.

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Investment advice offered through JOHN BAILEY FINANCIAL, a registered investment advisor and separate entity from LPL Financial