You’re a smart investor. You make rational decisions. You do your research before investing. But emotion may unwittingly be playing a role in how you invest — whether as a member of an investment committee or private investor — driving you to make decisions based not on facts but on heart and gut feelings.
“Traditional finance is based on the idea that investors are rational and do not allow fear or greed to influence their decisions,” says Matthew A. Shannon, CIMA®, Managing Director – Investments, Senior Institutional Consultant, Legacy Strategic Asset Management of Wells Fargo Advisors LLC. “Behavioral finance, on the other hand, takes into consideration the role that psychology and emotions can have when making financial decisions and incorporates that behavior into decision-making.”
Smart Business spoke with Shannon about how emotional biases influence investments and how an expert adviser can help you recognize — and counter — them when making financial decisions.
How do emotional biases impact financial decision-making?
We are living in a higher emotional state, with access to a lot of information. Humans naturally have a greater propensity to make decisions based on emotion in times like these, and not just about investments. While emotional decision-making may work in some aspects of life, going with your gut on investments is generally misguided.
There’s a premise that people, given similar information, tend to act similarly in decision-making, but not everyone will react rationally, especially in extreme circumstances.
What are some types of emotional biases?
Loss aversion is the natural tendency to try to avoid loss, because the pain of loss hurts twice as much as the pleasure of gain. If the market is down, people try to time it because they can’t take the loss. They know markets ebb and flow, but they are so afraid to lose that they make bad decisions to avoid a loss.
With regret aversion, people avoid making any decision for fear of being wrong, so afraid of regret that they don’t do anything. With the market, sometimes rebalancing is the right thing to do, and failure to act can be a negative. Overconfidence bias is a tendency to believe your judgment is better than it is. While self-confidence is good, most people believe their judgment is better than others, which can lead to bad decisions.
Finally, confirmation bias is prevalent. People in general only look for views that match theirs. But basing investment planning on an emotional response can result in potentially bad investments. When you can trade your entire 401(k) on your cell phone, you need to recognize that markets are extremely dynamic and carefully consider all angles before moving forward.
How important is working with a financial advisor?
Having a written plan takes emotion out of the equation. If you are an individual investor, work with a professional to go through the financial planning process in all aspects of your life. It’s not just investing that can fall prey to biases, but other financial moves.
Working with an adviser is critical. A professional can help define your individual needs and objectives, starting with a 30,000-foot view, then bringing it down to the investment level. But that plan is not set in stone; if things change, it needs to be dynamic. For both fiduciaries in an institutional setting and individual investors, the plan (often referred to as the Investment Policy Statement) lays out the dos and don’ts of what you are trying to accomplish, taking emotion out of the equation.
An adviser can help talk you out of irrational decisions based on a gut feeling. Emotions can be extraordinarily powerful, and they don’t magically disappear when investing. We’ve seen people work tirelessly with an adviser to form a plan, then throw it all away based on an emotional reaction to COVID, or the market declining.
Emotional biases are real in decision-making, and having a strategic, well-thought-out framework from which to make good decisions is critically important to achieving ultimate success.
Insights Wealth Advisory is brought to you by Legacy Strategic Asset Management