Don’t let emotional biases drive you off course

Behavioural economics is a science that challenges the traditional thinking that investors look for information and calculate costs and benefits to make a rational choice. In fact, a combination of time constraints, lack of knowledge and energy, and influence of emotions can lead people to make irrational and less than ideal investment decisions.

You may not even be aware of them or how they affect your financial well-being. An advisor can help you step back and see your behaviour objectively. Then, working together, you can map a road toward your long-term wealth goals.

Overconfidence bias

“Investing is simple. I can make better decisions than my advisor — I just use her for some ideas.”

People tend to overestimate their expertise. On tests, however, most self-proclaimed experts score below average.¹ Without the guidance of a trained financial professional, investors can make mistakes like over trading, or may not see the potential risks to their portfolios.

Loss aversion bias

“I would rather not lose any money than risk even a small loss to gain more.”

Most people feel the pain of a loss more sharply than the pleasure of an equal gain. In other words, the unhappiness of losing $10 is greater than the happiness of finding $10. This loss aversion is why people may leave money in a savings account that earns less than the rate of inflation. It’s also why investors may be willing to take a risk to avoid a potential loss but unwilling to take a risk to catch a similar potential gain.

Illusion of control bias

“I can control my returns by timing the market.”

Some people try to buy when an investment is at its lowest point and sell when it peaks. Problem is, highs and lows are often clear only in hindsight. Most investors end up locking in losses and then missing the upturn. The tendency for people to believe they can control outcomes in situations where they can’t may urge them to take action when they likely shouldn’t.

Representative bias

“This investment has been underperforming, so it will continue to underperform.”

Do you try to predict the future based on past experience? People often assume likelihood from similarity, and possibly neglect more important facts. While investors may consider recent returns will reflect future returns, the reality is that history doesn’t always repeat itself.

Confirmation bias

“I’ve seen that information before. It must be true.”

Have you ever looked up information to confirm something you believe while ignoring any information that might disagree with you? People often overvalue opinions that match their ownand,as a result, may tune out vital information. Confirmation bias can make investors pay undue attention to or even actively look for information that confirms existing beliefs, whether that information is accurate or not.

Herd bias

“Everyone is buying, so I should too!”

Growing up, your parents may have warned you that if “everyone else is doing it,” it doesn’t always mean it’s a good idea. However, rather than analyzing an opportunity, herd investors will buy an investment simply because other people are buying.

Present bias

“I would rather have $100 now than $150 a month from now.”

Do you see your current needs as more important than your future needs? That bias prompts people to live beyond their means. For example, people often don’t put aside enough money for a comfortable retirement. And 94% of Canadians say their households are in too much debt.²

To learn more about behavioural economics and how it can help you make better financial decisions, contact your advisor.