Behavioral finance refers to the ingrained aspects of human decision-making processes. They do a good job of helping us make decisions in our daily activities, but can sometimes lead us down the wrong path when it comes to investing. When these biases are widespread it can create bubbles in the markets. When these bubbles eventually “pop” it isn’t a pretty sight. Here are the most common behavioral finance biases.
- Uninformed decisions. Investors sometimes act on instinct without a full view of the factual information needed.
- Recency bias. If you gamble once and win, you’ll be addicted for life. The psychology behind this common saying is that as humans we tend to take the data and experience of the markets and extrapolate them into the future indefinitely. But just because something happened a certain way today, doesn’t mean it will tomorrow as well.
- Primacy bias. The first experience of something is given more weighting than anything that comes after.
- Bias of loss aversion. Generally, investors are only willing to lose half of their principal in their investments if they think they can gain at least twice or more of their current balance. The reality is that they will seldom win out that way.
- Gambler’s fallacy (sunk-cost fallacy). This is holding on to a losing investment for longer than you should or selling off a winning investment too soon. Sometimes the best thing to do is just take the loss and move on or it could be to ride the storm and the rising tide that follows.
In order to avoid these behavioral finance biases you can educate yourself about the markets, become self-aware of your decision-making processes, and consult a professional. We at American Financial Planning would love to help. Contact us for more information.