How Psychological Biases Can Hinder Financial Success

By Jane Young, CFP, EA

We commonly assume that financial decisions are based on logical, well thought out conclusions. However, most financial decisions are heavily influenced by our emotions, attitudes, experiences, and behaviors. Cognitive biases and our mindset toward money have a significant impact on our investment philosophy, self-worth, sense of security, and definition of success. Understanding the psychological biases and beliefs that influence financial decisions is essential to effectively manage your money. Below are some cognitive biases and behaviors that can negatively impact your financial success.

Loss Aversion – The tendency to feel pain from a loss more intensely than feeling pleasure from a gain. The fear of loss often results in holding poorly performing securities for too long. This can prevent you from reallocating your portfolio to invest in more promising opportunities.

Risk Aversion – Is where more emphasis is placed on avoiding loss than earning a gain. This can result in an overly conservative portfolio with limited potential for long-term growth. An overly conservative strategy results in missed opportunities and a failure to meet your financial goals. Alternatively, strive to invest in a balanced portfolio where you assume some risk for a reasonable rate of return.

Confirmation Bias – A tendency to seek out and interpret financial information based on previously held beliefs and disregard or ignore information that contradicts your beliefs. This clouds your judgement and prevents objective analysis. To avoid confirmation bias, strive to gain information from diverse sources and keep an open mind.

Overconfidence Bias – This is characterized by investors who overestimate their ability to manage their finances and predict future financial outcomes. This often results in assuming excess risk. To combat overconfidence, establish a systematic process to periodically rebalance your portfolio and avoid timing the market.

Sunk Cost – Protecting or holding on to previous decisions because you have already made a significant investment. This can result in an emotional commitment to a bad investment. Once a purchase has been made it can be difficult to take a loss and admit a mistake was made.

Jumping on the Bandwagon or FOMO – Many foolish investment decisions are made from the fear of missing out or FOMO.  Investors observe others buying a specific security or stock in a particular industry and they want to jump on board. Unfortunately, this often results in buying when the market is high and selling when the market is low. Instead of chasing the crowd, invest in accordance with your own values and goals.

To combat psychological biases, work to identify and acknowledge what triggers you to make emotional decisions. When you feel susceptible to an emotional trigger take a pause and give yourself some time to think and conduct additional research. Establish some clear financial goals and create a plan to keep you on track. It also may be helpful to automate your investments, educate yourself, practice mindfulness, and seek professional advice.