There’s More to Thinking Than You Think: Understanding How Biases Impact Decisions
The concept of behavioral finance is a relatively new field of study that combines psychological theory with conventional economics. We may not realize it, but we all have certain biases as investors, and that impacts the financial decisions we each make. Even the most disciplined investor may have difficulty overcoming personal biases – it’s how we’re wired!
In this series, we’ll explore some of the most common behavioral biases to which people find themselves susceptible, and how they could be holding us back. See previous article on Familiarity Bias.
Financial Bias #2: Loss Aversion
People often feel the pain of loss more vividly than the joy of gains, even when the gains are greater. When loss aversion takes hold, not only is a gain preferred over a loss, but avoiding losses becomes a top priority due to the possibility of feeling regret. Our aversion to loss can be felt across many aspects of our lives – making it difficult to part with everything from threadbare sweaters to under performing investments.
Money is frequently one of the things people are most afraid of losing, which means loss aversion can become even more influential – and potentially damaging – when it comes to your finances. This bias can affect your decisions by showing up in the following ways:
- Sticking with a portfolio that is extremely conservative to avoid potential financial loss
- Refusing to sell a stock for less than the price paid, clinging to a declining investment
- Putting off uncomfortable conversations about disability, long-term care, estate planning, etc.
- Holding on to possessions or investments that were gifted to you, even if they aren’t the best fit for your lifestyle or goals
- Taking unwise risks to try to counteract an existing loss
- Missing out on opportunities based on past negative experiences
Too strong an aversion to loss can hinder a financial plan’s progress. But it doesn’t have to be what holds yours back. Some ways to counteract loss aversion include:
- Look at your holdings with fresh eyes. If you were starting from scratch which would you still want to keep? Which could you part with?
- Give careful thought to what your true long-term risk tolerance is, and stress test your portfolio. This can give you the confidence to stick to the plan even when conditions or your circumstances get more volatile.
- Look past loss. Instead of dwelling, focus on how moving forward can help you keep progressing toward your goals.
- Look at long-term market data. While events like the financial recession and dot-com bubble were extremely significant at the time, when seen in the context of a longer time span, they were temporary speed bumps in the consistent growth of the market.
While it’s natural – and often prudent – to try to avoid loss, letting that fear loom too large over your financial decisions could actually lead to the very thing you’re afraid of. Work with your financial planner to cultivate a healthy relationship with risk by giving you objective feedback and perspective.
Written By Kimberly S. Baker, CFP®