Kevin Ihrke, CFP®
I lived in Los Angeles for almost ten years. I’ve seen my fair share of bumper-to-bumper traffic, fender benders, and reckless drivers.
The worst encounter was when someone would cut me off trying to exit the freeway at the last second. It’s not only frustrating – it’s dangerous.
The late, great comedian George Carlin used to say, “Have you ever noticed that anybody driving slower than you is an idiot, and anyone going faster than you is a maniac?” (And that’s putting it nicely.)
Our usual knee-jerk reaction is to immediately assume the worst about that person. We’re reacting in such a way as though our assumption – our perception of the situation – is correct.
The reality is we don’t know.
Maybe the person is late for work and could face termination if they don’t get there on time. Or maybe the person is rushing to the hospital in an emergency. It doesn’t necessarily excuse their behavior, but the fact is, our assumption that they’re either an idiot or a maniac, could be wrong.
We’re human though. We’re emotional creatures, whether we wear our emotions on our sleeve or not.
And when it comes to our money and personal finances, our emotions don’t magically go away. Quite the contrary. Money is personal and it can be very emotional.
We all have a relationship with money based on our upbringing, past experiences, and belief systems. Taking an objective approach to managing our own finances can be challenging at times. It’s easy for emotion to cloud our judgement when it comes to reaching our long-term financial goals.
Objectivity is a key component of a successful financial plan.
There’s an entire field of study dedicated to the intersection of psychology and money called Behavioral Economics. Its primary focus aims to overhaul the traditional economic theory that people are rational, self-interested beings when it comes to their interactions with money and consumption.
Instead, behavioral economics understands we’re emotional beings. It focuses on the personal framework and cognitive biases that we’re all susceptible to when making financial decisions.
Think about your financial life. Have you ever made a decision that seemed rational at the time only to realize later it didn’t turn out the way you planned. Or worse, you found yourself in a financial jam. It happens. And it likely happened because your cognitive biases got the best of you. Objectivity was an afterthought.
As investors, it’s important to be aware of how our cognitive biases can impact our financial decisions. Our biases can deter us from reaching our goals and ultimately hinder the performance of our investment portfolios.
I’ve listed some of the more common biases that exist among investors and some ways you can counter them.
- Overconfidence Bias:
One of the most prevalent biases in investing is overconfidence. This bias can cause you to overestimate your knowledge, skills, and abilities. Overconfident investors often fall into the trap of believing they can consistently beat the market. This can lead to excessive trading, excessive investment risk, or overconcentration of a particular investment. It can also lead to just being flat out wrong and finding yourself with subpar returns or substantial losses.
Objectivity is key. You don’t know what you don’t know. Seek advice and feedback from trusted sources. Ask yourself the simple question, “What if I’m wrong?” and remember, not even the pros can consistently outperform the market.
- Loss Aversion:
No one likes to suffer a loss. The potential for loss though is part of investing. Loss aversion occurs when you prefer avoiding losses over acquiring equivalent gains. This bias can lead you to hold onto losing investments for too long, hoping they’ll recover. Or sit in conservative investments, forgoing potential gains, in an effort to avoid market volatility. This behavior can hinder long-term portfolio performance and lead to missed opportunities.
Instead, know your tolerance for risk. Make sure it’s aligned with your desired timeframe and long-term objective. Remember that the value of your investments will fluctuate from day-to-day. Avoid emotional decision-making during periods of market volatility and set predefined exit criteria before entering a new investment. And maintain a diversified approach with your investment strategy to mitigate the impact of individual investment losses.
- Confirmation Bias:
Confirmation bias is the tendency to seek out information that confirms preexisting beliefs or opinions while ignoring evidence that contradicts them. This bias can cause you to selectively interpret information in a way that supports your existing thesis while ignoring any counter argument. This can be detrimental when it comes to your investments.
As with most things in life, seek out diverse perspectives and alternative viewpoints. Engaging with dissenting opinions and conducting thorough research can help you make more informed decisions about your investments.
- Herding Behavior:
Herding behavior occurs when you decide to follow the actions of the crowd, even if those actions are irrational or contrary to your own beliefs. This behavior can lead to market bubbles and crashes as investors collectively rush to buy or sell assets based on the actions of others rather than objective analysis.
Rather than following the crowd, stay focused on your own goals and objectives. Worry less about what the market is doing and focus more on what it can do for you in the long run. Maintain a disciplined approach with your investment strategy and be skeptical when everyone on Wall Street seems to be in agreement about something.
- Recency Bias:
Recency bias occurs when you give more weight to recent events or performance when making investment decisions while ignoring longer-term trends or historical data. This bias can lead to chasing returns or reacting impulsively to short-term market movements, rather than adhering to a consistent investment strategy.
Avoid making knee-jerk reactions to short-term market fluctuations. Focus on the big picture – your goals and objectives. And keep in mind that markets can be volatile from day to day. For prudent long-term investors, returns happen over time.
Overall, successful investing requires a combination of rational analysis and emotional discipline. Have an understanding and awareness of your own biases. Objectivity is a crucial component when it comes to navigating the complexities of your financial life.
Avoid making emotional decisions in the heat of the moment. Take time to reflect on your situation and think through potential outcomes before acting. And remember to ask yourself, “Why?” and “Why now?”
And next time you’re stuck in traffic, remember not everyone is an idiot or maniac.
Kevin Ihrke is a CERTIFIED FINANCIAL PLANNER™ professional. His firm, Investment Insights, LLC is located at 508 N 2nd Street, Suite 203, Fairfield, IA 52556.
Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization’s initial and ongoing certification requirements to use the certification marks.
Securities offered through Cambridge Investment Research, Inc, a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Investment Insights, LLC and Cambridge are not affiliated.
Comments and questions can be sent to kevin.ihrke@emailsri.com. These are the opinions of Kevin Ihrke, CFP® and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.