The Psychology of Money and Investing

It has often been said that “We are our own worst enemy.” I have studied the psychology of money for over 15 years. Basically, it is the study of our behavior with money. Becoming good with money isn’t about knowledge, IQ, or how good you are at math. It’s about behavior, and all of us are subject to certain behaviors that can make us make emotional decisions.

Cognitive Biases and Investing

Cognitive biases are inherent psychological tendencies that influence our decision-making processes. In the world of investing, these biases can significantly impact our judgment and lead to irrational behavior.

I want to look at 8 behaviors we all will encounter when owning investments, especially individual stocks.

Number 1: Confirmation Bias

This bias refers to the tendency to seek out and interpret information in a way that confirms our existing beliefs or assumptions. In an investment context, individuals might actively seek out information that supports their decision to invest in a particular stock, while ignoring or downplaying contradictory data.

This can prevent us from objectively assessing the potential risks and returns associated with an investment. It stems from the natural human tendency to intensely dislike losses more than we enjoy gains. As a result, investors may hold on to losing investments for longer than necessary, hoping that they will eventually turn around. This aversion to accepting losses can prevent individuals from making rational decisions and can ultimately harm their investment portfolios.

Number 2: Overconfidence Bias

Overconfidence bias occurs when individuals overestimate their abilities and knowledge, leading them to believe that they possess superior investment skills. Overly confident investors are more likely to engage in risky behavior and make speculative investments without conducting thorough research. This bias can significantly increase the chances of incurring substantial financial losses.

Number 3- Herd Mentality or Bandwagon

This bias refers to our inclination to follow the actions and opinions of the majority. In investing, this can lead to excessive buying or selling based solely on the actions of others, rather than conducting independent analysis. Succumbing to the herd mentality can result in the formation of speculative bubbles and exaggerate market volatility.

Number 4- Hindsight Bias

Hindsight bias is the tendency to believe that your past positive outcomes were a result of your ability to understand and predict what the market will do. It is also the belief that negative outcomes are the result of events that cannot be predicted.

Number 5- Recency Bias

Recency bias is the tendency to give more weight to more recent information compared to much older information. The belief is that the current information can influence the future more than the older information, which is generally considered useless. For instance, if you hold a position on a particular stock, you can give more weight to a recent positive managerial change while conveniently ignoring that the company missed its earnings call by a big margin last quarter.

Number 6- Anchoring Bias

Anchoring bias is the tendency to apply more weight to a single piece of information when making important investment decisions. For instance, if you are looking to buy a stock that is trading at $20, you may focus more on the current price while ignoring other factors. This may be because you recall that the stock once traded above $80, which implies that the current price must be cheap.

Number 7- Loss Aversion Bias

It is a natural human tendency to avoid losses. Investors who suffer from loss aversion bias are more eager to avoid losses than to pursue gains. This bias can work against investors because it clouds their sense of measuring opportunity cost. For instance, if you have bought into stock A, which is currently losing 50%, but you are unwilling to cut your losses to take a high probability opportunity in stock B. Investment is a game of risk and reward, and investors should be willing to accept losses from time to time, as much as they are always eager to obtain rewards.

Number 8- Status Quo Bias

Status quo bias is the tendency to avoid making decisions that may alter the current situation of an investment. It is an irrational desire to want things to stay the same. Investors who suffer from this bias avoid changing their minds even when presented with facts or information that say otherwise. For instance, an investor who believes stock A is in a long-term rally will consider price drops as just short-term ‘noise’ rather than an actual change in trend.

To reduce the impact of cognitive biases on investment decisions, it is crucial to use methods and techniques that encourage unbiased and objective thinking. Some of the strategies that can help overcome these biases include diversification, carrying out thorough research, setting specific investment objectives, and seeking advice from a reliable financial advisor.

At Momentous Wealth Advisors, countering cognitive biases is central to our investment philosophy. By providing comprehensive portfolio analysis, conducting thorough market research, and offering unbiased advice, we strive to help our clients make informed and rational investment decisions. Overcoming cognitive biases is a continuous process, but with the right approach and guidance, investors can navigate the complexities of the market and achieve their financial goals.

-Brian D. Muller, AAMS® Founder, Wealth Advisor

Disclaimer: This material is for informational purposes only and should not be construed as investment advice. Past performance is not indicative of future results. Investors should make investment decisions based on their unique investment objectives and financial situation. While the information is believed to be accurate, it is not guaranteed and is subject to change without notice.

Investors should understand the risks involved in owning investments, including interest rate risk, credit risk and market risk. The value of investments fluctuates and investors can lose some or all of their principal.

Always consult with a qualified financial professional before making any investment decisions.