There’s More to Thinking Than You Think: Understanding How Biases Impact Investment 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.
Financial Bias #1 – Familiarity
Familiarity is the reason you fill your grocery cart with the same brands on every shopping trip, why you repeatedly choose the same route to work each morning, and why the more you hear a song, say a name or visit a place, the more you tend to like it. It’s the instinct to favor what we know, and drives us to be loyal to the things we’re exposed to the most.
Studies have shown that not only do we favor what we know, we also assign higher value to it. In the case of financial planning, leaning too heavily on the familiar can lead to an under-diversified portfolio. By trying to play it safe, people who stick with what they know might actually be inviting risk.
Familiarity is often the culprit behind over-weighting in U.S. stocks (also known as home country bias), or portfolio over-concentration (a substantial portion held in just one or two well-known names or industries).
Although there’s much to be said for the comfort of sticking with the familiar, clinging too tightly to what you know can put your plan at risk. While the unknown can be a risk, the well-known isn’t always the better choice. Learning to resist the lure of the financially familiar can help you broaden your potential by striking the right balance.
So what can you do to combat this bias? Do some of your own research to learn about different approaches, rather than sticking with only the strategies in your comfort zone. Seek out the perspectives of people whose beliefs differ from your own. And work with your financial planner to provide objective insights and perspective, helping guide you toward financial success.
Written By Kimberly S. Baker, CFP®