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Written by: Ashley Perlmutter
People always say don’t let your emotions take control and drive your big decisions. While true, this statement is much easier said than done, especially when it comes to your finances. At Sherman Wealth, we often discuss behavioral finance with our clients and how behaviors can drive or impact our financial decisions as humans.
You may not even know or be able to see it, but there may be a number of psychological biases holding you back from building your wealth. That’s because the part of our brain that allows us to imagine the future doesn’t move as fast as the part that governs emotions. The emotional part of our brain is not naturally trained how to operate the modern economy as it is to build relationships.
The good news is there are things you can do to overcome these biases. By acknowledging and familiarizing yourself with these behavioral biases, you can teach yourself to avoid them when you come across them. Here are some major behavioral biases to watch out for:
1. Loss aversion
By far the most powerful emotional bias, loss aversion refers to the desire to avoid any risk that could result in a loss. It could lead investors to sell something after it has fallen in price and buy more of something that has gone up. Instead, make your investment decisions using the rational part of your brain and then ignore them, he advised. Set up a system that will automatically rebalance your portfolio so that you aren’t making changes based on emotion.
2. Endowment effect
People tend to value something more highly once they own it. For instance, you may have inherited some stock from a relative or invested in an asset that has gone up in value. Once you become emotionally invested in something, it’s often hard to let go, in this case, hard to sell a stock. However, if it takes up a big portion of your portfolio, that means a lot more risk. Instead, think rationally about your choices and make sure you have the right mix of assets for your needs.
3. Sunk cost fallacy
This occurs when you keep investing money in a losing project because of prior investments you have made, such as spending $2,000 repairing a car that keeps breaking down. You don’t want to buy a new car because of how much money you’ve already put into the vehicle. Do not dwell on poor decisions, focus on making better ones in the future.
4. Status quo bias
When you do nothing because you are afraid of a negative outcome, even though the decision may be worth the risk, it is considered a status quo bias. For instance, you may hold onto a stock that has lost value because you don’t want to take a loss.
Instead, think rationally about the price and how it compares with expected future prices and dividends. Also remember that there are tax advantages to taking losses when it makes smart investing sense. When you sell assets at a loss, it will make up for some of the gains you made — which should reduce the amount of taxes you’ll have to pay.
5. Bandwagon effect
Just because everyone is buying a stock doesn’t mean it is right for you. Yet people feel safer following the crowd. The recent meme stocks and short selling are a great example of this effect. Individual investors piled into the stocks after being prompted by social media, and many may have lost money amid the volatility.
6. Confirmation bias
People often seek out information that confirms their previously held beliefs. However, it’s important to get your information from a variety of sources so that you can make informed decisions.
Confronting these behavioral biases can help you avoid making clouded decisions in the future.
Related: Unpacking the Stagnant Stock Market