You are faced with decisions every day, some more difficult than others. Take food for example: If you are presented with both a salad or a cake, you may be tempted to skip the healthy greens for dessert.
For many people, this is a challenging decision. You know the salad is good for you, but the cake looks much more appetizing. In order to decide, the frontal cortex of your brain processes information to help you make a logical or informed decision.
However, the amygdala may have other plans. This is the reflexive piece of the brain connecting stimuli to experiences. In this instance, it is connecting the taste of past experiences with both the cake and the salad.
The cake may be associated with a positive experience, such as a birthday, which is why you may be more tempted to choose this option.
The amygdala is associated with flight or fight responses, so you can see how letting this part of your brain control reactions when making financial decisions may lead to an outcome less than desirable – similar to a stomachache after indulging in too much cake.
The amygdala is your bias. Bias refers to a tendency, trend, inclination, feeling, or opinion, especially one that is preconceived or unreasoned. Bias is often drawn from a past experience.
It’s important to have an understanding of how impulsive and reflexive behavior can impact your decision-making ability and result in impacted investments.
Here are the six concepts of bias that can impact how you invest:
Mental Bias and How It Affects Your Investments
1. Availability Bias
Availability bias is when thinking is strongly influenced by personal thoughts or experiences most relevant, recent, or traumatic. For example, something traumatic will stick with you and can affect how you respond or make decisions due to your experience with a similar event.
When the stock market took a downturn in 2008, investors perceived the market in 2009 to be down or flat as well, when in fact the market was up. As the downturn was a traumatic experience for those in the market, investors decided to pull their investments.
The danger of basing investment decisions on perceptions is investors may pull their money at the wrong time, missing some of the best days of the market.
It’s normal to feel the most comfortable following the crowd because we fear making mistakes or missing opportunities. We assume the consensus view to be the correct one.
Looking at bubbles throughout history, investors may have feared missing out on what, at the time, looked like an amazing opportunity. A bubble is a situation in which asset prices appear to be based on implausible or inconsistent views about the future.
This tends to drive the market to unsustainable levels, often within a small timeframe. Faster than levels grow, they can burst and drop by a substantial amount. Investors tend to jump on the bandwagon based on emotions rather than strategy, which can cause loss.
3. Loss Aversion
Loss aversion is the preference to avoid losses because the associated pain is much more intense than the reward felt from a gain. Studies have shown the pain of a loss is almost twice as strong as the reward felt from a gain.
As an emotional investor, decisions tend to be made to avoid the pain of loss. For example, when a bubble bursts, investors may panic and pull their money out of the market. To avoid more losses after a market crash, investors may be tempted to move their investments to a place they perceive as a safe haven, such as cash holdings.
However, what investors may not realize is this security comes at a cost. Investors may be surprised to learn, once inflation is factored in, staying in investments they may consider more secure while they wait out stock market volatility may lead to the erosion of their purchasing power.
4. Present Bias
Present bias is also known as immediate gratification bias, and it occurs when we overvalue immediate rewards at the expense of long-term goals. The tendency to focus on the now can be seen in our national savings rate.
Over the last 60 years, the percentage of disposable income people save has generally trended downward. And as a result, lack of planning and saving is having a significant impact on those nearing retirement.
Anchoring is the tendency to focus too heavily on one piece of information when making decisions. A common example is searching for an airline ticket online. Say you are searching for a ticket and it is originally quoted at $400, but you don’t purchase it right away and when you come back it is $500.
Now, what if the original quote was $600, but when you come back it is $500 — how might your emotions differ? In both scenarios your purchase price is the same, $500, but your feelings toward the decision are vastly different based on the price you used as your anchor.
Anchors have a powerful hand in our decision making and can create unrealistic expectations for investors.
6. Home Country Bias
Home country bias can be described as our natural tendency to favor companies and products from our home country or region. Where we live has a big influence on our everyday lives, for example where you live might determine whether you say soda, pop, or coke.
Where we live also influences where we invest. While average US retail investors prefer domestic investment opportunities, they may be missing out on opportunities offered by foreign investments.
In summary, we have looked at several biases that affect us as humans, but more importantly as investors. It’s important to keep these biases in mind as we invest and experience the ups and downs of the stock market. So, what can you do now to make better financial decisions?
A financial professional can assist you in building a long-term investment strategy to help achieve your goals, keep emotions and biases in check, and stay on track with regular portfolio reviews and adjustments.
For a further in-depth analysis on the topic please visit General Electric Credit Union’s CU Events Page to view our on-demand webinar, Six Barriers to Investment Success: Uncovering Your Behavioral Biases.
Ready to begin planning, but not sure where to start? Contact Todd Blessing with Investment Services* today at 513.243.4328 x173 or Todd.Blessing@cusonet.com or Erik Waldron with Investment Services at 513.243.4328 x305 or Erik.Waldron@cusonet.com.
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*Non-deposit investment products and services are offered through CUSO Financial Services, L.P. ("CFS"), a Registered Broker-dealer (Member FINRA/SIPC) and SEC-registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. General Electric Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.