Have you ever outlined your ideal financial plan, or made a decision about your investing, only to change your mind at the last minute? Maybe you suddenly felt uncomfortable with your decision, or you were worried that you’d be missing out if you didn’t sell your company shares. Maybe you told your coworker about your newly minted financial goals for the year, and immediately felt uncertain when you realized that they had even bigger, seemingly more exciting goals in their own life.
Financial planning is often thought to be just about the numbers, but that notion isn’t accurate. Yes, it’s important to have the dollars and cents of your financial plan buttoned up. However, understanding the behavioral aspect of your wealth management can help you make informed decisions, and plan ahead for those moments where you feel compelled to pivot your strategy.
The truth is that behavioral finance is something that not many people study, but it directly impacts your financial decisions and actions. Understanding what psychological concepts are at play when you make decisions about your wealth can help you make the most comfortable or logical decision for your unique situation depending on the goals you want to achieve. Let’s dig into a few key behavioral finance concepts, and how they could impact you.
Recency Bias
We all have a cognitive bias, called the recency bias, that forces us to focus on recent information rather than historical evidence. In life, this can show up in many different ways.
For example, you may have had a long-term friendship that went sour because, at one point, your friend did something to violate your trust. Even though you had several years of evidence showing that they can be a trustworthy friend, the recent event that left a bad impression was all you could focus on.
In these instances, the recency bias can be useful and protect us from falling into a trap of doing things because “that’s how they’re always done.” Focusing on recent information can push you to make decisions with the most up to date facts and impressions, and help you make forward progress.
This can be accurate in your financial plan, as well. For example, if you have seen that the market has recently been a bull market, you may start to feel that it’s time to get more aggressive. The odds of feeling greedier because you’ve seen a lot of recent gains or success in investing skyrocket in a bull market.
On the other side of the coin, if the market recently experienced a downturn, you may be tempted to make the impulse decision to sell all of your shares even if you can look back on the market for the past 25 years and see that downturns always correct themselves with time. When you make these decisions based on recency bias, you could potentially invest in a way that either exposes you to too much risk based on your financial goals or miss out on potential gains.
Herd Mentality
If all of your friends jumped off a cliff, would you do it, too?
This old saying is one people use to teach their kids to think independently or to do the right thing in life. It can also be applied to financial planning!
It’s hard not to want to do what you see the “group” doing. That group can be other investors, family members, or even colleagues at work. The important thing to remember is that your situation is unique to you.
Even if you feel like someone else is making a decision that sounds appealing, or several other people are making similar wealth management moves, that doesn’t mean it’s right for you. Consider your own goals before joining the group.
Loss Aversion
Most people have a strong loss aversion. This means that, as humans, we are more concerned about experiencing loss than we are about achieving gains. You can likely see this in your personal life. You’re more concerned about giving something up – a job, your current house, a convenient circle of friends – to go for something bigger like launching your own business, moving to a dream location, or finding new friends who have a value set closer to your own.
Investors experience this same aversion, and it shows up as a low tolerance for risk in their portfolio. For example, you may have several years until you retire, but are still worried about taking on too much risk in your portfolio – even if it could mean adequate gains to move you toward your retirement savings goals, or other financial milestones.
Combatting Biases in Behavioral Finance
These are only three of the many different cognitive biases you face when dealing with wealth management. It’s important to understand that you will never make “perfect” decisions because of these biases, and that’s okay. Being aware of the biases you have can help you evaluate reactions or impulse decisions to help you stick with your plan and look at the big picture. If you ever feel like a cognitive bias is pushing you to make a decision about your finances, don’t hesitate to reach out to your advisor to talk it over. Financial advisors can act as a sounding board and impartial third party to help you consider every angle of a financial decision.