How to Combat Behavioral Biases in Your Personal Finance
Presented by: Advisor, Maggie Johndrow
Co-authored by: Intern, Evelyne Beaule
When faced with complicated choices, we often take many mental shortcuts, which can lead to faults in how we deal with our money. When thinking about your finances, you must consider the biases that cause us to make irrational financial decisions. Behavioral biases can influence investors’ decisions and judgments about how we spend our money and interpret specific information in the financial markets. In this blog, I will review the three main biases that may be causing you to make poor choices in the financial world. By understanding each bias, it will help you overcome them and learn how to nudge yourself in the right direction.
1. Loss Aversion
Many of us are susceptible to loss aversion, which is the bias that leads us toward avoiding losses rather than seeking gains. This is because humans perceive an actual or potential loss as emotionally more severe than an equivalent gain for investors. The problem is that this bias causes people to avoid small risks even when they can be worth it in the long term, and you sometimes have to ride them out. One example of this bias is that if someone were to lose $100 on an investment, it is thought of as much more painful than the joy of receiving $100 for a return on investment. A nudge tactic that may be used in this situation is to create an investing strategy and stick to it, despite the minor bumps in the road. It is beneficial to adopt some risk management by considering assets that perform well and will benefit you in the long term. All in all, try not to back down when you experience a little loss because your gain could be twice as significant in the future.
2. Present Bias
Present bias is another behavioral tendency that investors fall into the trap of. This bias is the tendency of people to discount their future in favor of immediate gratification. This causes us to place more value on things in the present rather than the future. We make decisions based solely on thinking about the present, which causes our future self to be regretful because we disregard the fact that we might need it in the future. The problem with this bias is that it causes people to have insufficient savings because they aren’t thinking that far into the future. For example, people will often say, “Oh, retirement is so far away, I don’t need to be saving for that right now… Instead, I’ll just spend my money on something that will only last me a few years and not benefit me at all.” This is actually classic human behavior. People under the influence of present bias spend too much, borrow too much, and don’t save enough. A nudge tactic to overcome this bias is to devise a financial plan to commit to so you know exactly how much you would benefit if you were to start saving right now based on the fact that you’re susceptible to this bias.
3. Overconfidence Bias
Lastly, overconfidence bias is the tendency for people to overestimate their abilities and lead them to think they’re better than an expert investor. It can lead to risky investments as people susceptible to this bias don’t manage and control their risk correctly. They overestimate their understanding of financial markets or investments and often disregard data and expert advice. The problem with this bias is that it tricks an investor’s brain into thinking it is possible to constantly beat and accurately time the market by making risky bets, despite markets being known for their unpredictability. One example of this bias is someone believing they can pick the next big stock and, as a result, end up investing in many risky stocks that may not benefit them. A nudge tactic that could fight this bias is conducting an analysis or consulting a professional to hear various perspectives about your investing strategies and passively investing to avoid attempting to time the markets.
By understanding that investments, risk, and personal finance are all influenced by human emotions and behavioral biases, we can improve how our minds process and respond to information to make more rational decisions in financial matters.
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Presented by: Advisor, Maggie Johndrow
Co-authored by: Intern, Evelyne Beaule
Evelyne Beaule is a new part of the Johndrow Wealth Management team with her role being an intern. She is a senior at Miss Porter’s School and is looking forward to attending Connecticut College in the near future. She is interested in behavioral economics and looks to gain experience in the financial world to lead her studies and what she might do in the future.