How biases can affect investment decisions

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Over the past few decades, a new school of thought has emerged that examines how human psychological factors influence economic and financial decisions. This field — known as behavioral economics, or in the investing arena, behavioral finance — has identified several biases that can unnerve even the most stoic investor. Understanding these biases may help you avoid questionable calls in the heat of the financial moment.

Sound familiar
Following is a brief summary of some common biases influencing even the most experienced investors. Can you relate to any of these?

  1. Anchoring — is the tendency to become attached to something, even when it may not make sense. Examples include a piece of furniture that has outlived its usefulness, or a home or car that one can no longer afford. In investing, it can refer to the tendency to either hold an investment too long or place too much reliance on a certain piece of data or information.
  2. Loss-aversion bias — describes the tendency to fear losses more than celebrate equivalent gains. For example, you may experience joy at the thought of finding yourself $5,000 richer, but the thought of losing $5,000 might provoke a far greater fear. Loss aversion could cause you to hold onto a losing investment too long, with the fear of turning paper loss into a real loss.
  3. Endowment bias — is similar to loss-aversion bias and anchoring in that it encourages investors to “endow” a greater value in what they currently own over other possibilities.
  4. Overconfidence — is simply having so much confidence in your own ability to select investments for your portfolio that you might ignore warning signals.
  5. Confirmation bias — is the tendency to latch onto, and assign more authority to, opinions that agree with your own.
  6. The bandwagon effect — also known as herd behavior, this happens when decisions are made simply because “everyone else is doing it.”
  7. Recency bias — occurs when recent events have a stronger influence on your decisions than more distant events. For example, if you were burned by the market downturn in 2008, you may have been hesitant about continuing or increasing your investments once the markets settled down. Conversely, if you were encouraged by the market’s subsequent bull run, you may have increased the money you put into equities, hoping to take advantage of any further gains.
  8. Negativity bias — indicates the tendency to give more importance to negative news than positive news, which can cause you to be more risk-averse than appropriate for your situation.

An objective view
The human brain has evolved over millennia into a complex decision-making tool, allowing us to retrieve past experiences and process information so quickly that we can respond almost instantaneously to perceived threats and opportunities. However, when it comes to your finances, these gut feelings may not be your strongest ally, and in fact may work against us. Before jumping to any conclusions about your finances, consider and work through any biases that may be at work beneath your conscious radar.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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