If you're like most people, you go through many complex thoughts and emotions when choosing investments. In fact, a field of study called "behavioral finance" is devoted to understanding why people make their investment decisions. As part of their work, behavioral finance researchers examine "biases" that affect people's investment selections. And as an individual investor, you, too, can benefit from understanding these biases — so that you can avoid them.
Here are some of the key biases identified by behavioral finance experts:
• Overconfidence — Overconfidence leads investors to believe they know the "right times" to buy and sell investments. But if you're constantly buying and selling in the belief that you are correctly "timing" the market, you maybe wrong many times, and you may incur more investment fees, expenses and taxes than if you simply bought quality investments and held them for the long term.
• Representativeness — If you make decisions based on preconceived ideas or stereotypes, you may be suffering from a bias called "representativeness." For example, if you see that investments from a particular sector, such as energy, have performed particularly well in one year, you might think these types of vehicles will do just as well the next year, so you load up on them. Yet every sector will go through ups and downs, so one year's performance cannot necessarily predict the next year's performance. Instead of chasing "hot" investments, try to build a balanced portfolio that reflects your individual goals, risk tolerance and time horizon.
• Anchoring — Similar to representativeness, an anchoring bias occurs when investors place too much emphasis on past performance. If you own shares of XYZ stock, for instance, and the stock price hit $60 per share, you might assume XYZ will always sell for at least $60 a share. But if XYZ drops to $30 per share — perhaps as a result of a broad-based market decline — you might think it's now "undervalued," leading you to "snap up" even more shares. However, XYX shares could also fall due to a change in its fundamentals, such as a shake-up in the company's management or a decline in the competitiveness of its products. As an informed investor, you need to work with your financial advisor to determine the causes of an investment's decline and any actions you may need to take in response.
• Confirmation — If you are subject to confirmation bias, you may look for information that supports your reasons for choosing a particular investment. This type of bias can lead to faulty decision-making, because you'll end up with one-sided information. In other words, you may latch onto all the positive reasons for investing in something — such as a "hot stock" — but you may overlook the "red flags" that would cause you to think twice if you were being totally objective. To fight back against confirmation bias, take your time before making any investment decision — a quality investment will almost always be just as good a choice tomorrow as it is today.
Being aware of these investment biases can help you make better decisions — and over a period of many years, these decisions can make a difference as you work toward achieving your financial objectives.