Human beings have come a long way for a species that has only been around for roughly 300,000 years – a drop in the ocean compared to the approximately 4.5 billion years our planet has existed.
Our species has rapidly evolved, developing civilisation, tools, and within the last century technological marvels, such as space travel and artificial intelligence. Yet, despite all that progress, we are still prone to act on instinct and subconscious impulses.
These psychological biases can affect the best of us and could have the undesired effect of skewing your better judgement and decision-making.
When investing your wealth, the consequences could be detrimental to your finances and your progress towards your long-term goals.
Here are four psychological biases you might want to better understand. That way, you can avoid succumbing to their influence and ensure you continue to make logical, well-informed investing decisions.
1. Loss aversion
The theory of loss aversion posits that the pain you associate with loss is felt twice as strongly as any joy produced by gains.
This emotional imbalance could prompt you to give into feelings of frustration, anger, and fear, which could be brought to the forefront during tricky periods for your finances and investments. For example, such as during a market dip or the ongoing cost of living crisis.
Periods of economic downturn can increase the pressure on you to protect your money and investments from the potential of losses. This may tempt you to sell to mitigate your loss, rather than hold on to your investments for the long term.
However, this can be a detrimental move, as it essentially converts what might have been a paper loss into an actual one. This also removes any possibility of your investment bouncing back in the future and producing gains.
Remember: if you focus on staying calm and view your investments with a logical outlook, you might be able to navigate around short-term dips, and continue onwards to the kind of growth needed to reach your long-term goals.
2. Confirmation bias
Confirmation bias refers to the tendency for people to seek out and gather information that confirms a pre-existing belief or viewpoint.
In regard to your investments, this might prompt you to:
- Skip careful research into your prospective investments
- Ignore information that conflicts with your viewpoint
- Overly rely on information that supports a pre-conceived investing decision you had hoped to make.
The problem presented by this bias and investing approach is that it could leave you blindsided by potential negative outcomes.
You may come to believe your investment is a “sure thing”, due to the information you’ve gathered that supports your belief. This could mean that, if an investment is unsuccessful, you are ill-prepared to deal with the consequences.
It is vital that you don’t rush into any investing decisions. There’s immense value in unbiased and thorough research. The correct amount of due diligence could be key to ensuring that the decision you end up making serves your best interests.
3. Herd behaviour
Herd behaviour is the instinct to follow the opinions or choices of others, rather than opt to make your own informed decisions.
When it comes to investing, this can be especially prevalent if you have loved ones or peers who routinely talk about investing in a certain stock or investment opportunity.
Alternatively, you might hear about a trend regularly on the news or social media and find it sparks your interest.
You might find yourself worrying about missing out on any potential returns that others could make if this particular investment pays off. As a result, you may decide to follow suit and commit your funds.
Herd behaviour has factored into many risky investment trends and market bubbles, such as:
- The dot-com bubble of the early 2000s
- The 2008 global financial crisis
- The rise of cryptocurrencies and NFTs.
The problem with herd behaviour, as with the instances mentioned above, is that when an investment heads in the wrong direction it could leave you exposed to losses. And you may end up investing in something that doesn’t tally with your personal tolerance for risk.
Investment trends, while potentially lucrative, might not fit into your overall wider financial plans, either.
It is important that you remember to think for yourself and avoid simply following the herd.
4. The overconfidence effect
The overconfidence effect sees your perception and decision-making skewed by an unearned belief that your better judgement is greater than its actual objective accuracy.
For example, you could fall victim to this bias if you have a rush of short-term investments that produce significant returns.
According to ResearchGate, the overconfidence effect has the ability to push investors to overestimate their own abilities and knowledge, which might lead to harmful outcomes for their finances.
If you find yourself feeling like “nothing can go wrong” and believing your investments will continue to head in a positive direction, you might have succumbed to a degree of overconfidence.
It is important to remain level-headed and ensure that any investments you make are carefully aligned with your personal tolerance for risk. So, if the worst occurs, you are capable of handling any potential losses and bouncing back to continue onwards towards your long-term goals.
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If you have any concerns regarding your investing outlook and feel like a second opinion might help you make more well-informed choices, please reach out to us.
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This article is no substitute for financial advice and should not be treated as such. To determine the best course of action for your individual circumstances, please contact us.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.