Our thinking processes, while often helpful, can also be detrimental to our financial decision-making process. According to behavioral finance theory, mental shortcuts or errors in judgment can lead to irrational decisions.
By understanding the types of cognitive biases and how they shape our decision-making process, investors and financial planners can become better prepared to make sounder financial decisions.
Types of Cognitive Biases
Cognitive bias can be defined as a mental error affecting how we think and process information, leading to an irrational decision. Some of the most common cognitive biases in finance are:
- Confirmation bias
- Anchoring bias
- Overconfidence bias
Confirmation bias occurs when an individual seeks evidence to support their beliefs while disregarding contradictory evidence. For example, an investor may seek information about a stock that backs their preconceived notions while ignoring negative news. This type of bias can lead to making investment decisions not based on objective evidence.
Anchoring bias occurs when one fixates on the initial information they receive and fails to consider new or additional information. This error in judgment can prevent investors from recognizing investment opportunities or reacting to changes in the market.
It’s possible to overestimate your ability to accurately predict the future. Overconfidence bias can lead investors to take on more risk than is prudent or diversify too little, resulting in a suboptimal portfolio performance.
Overcoming Cognitive Biases
You can leverage the opinion of others to help you overcome your cognitive biases. When you get views from others, you’re exposed to different perspectives. This strategy can help you avoid confirmation and overconfidence biases.
As the adage goes, information is power. Therefore, you should research any investment in depth before dipping your toes into it. You should analyze all the relevant data and come up with concrete evidence to support or dismiss an investment.
Another essential aspect of overcoming your cognitive biases is to develop a systematic investment approach. A defined way of evaluating the investments you want to consider will save you from irrational financial decisions.
A systematic approach includes defining the evaluation process, waiting period, metrics to consider, and sources of information. This method ensures consistency. You can use previous information to make rational predictions.
Behavioral Finance Tools
Robo-advisors and automated algorithms provide data-driven advice based on an individual’s risk tolerance, time horizon, and other factors. The tools can easily process vast data and provide the necessary insights to make a decision.
When it comes to balancing your portfolio, automated algorithms can identify opportunities and alert you when you need to adjust your assets. Consequently, they reduce the margin of cognitive biases.
Although these tools can reduce cognitive errors, they’re only as good as the data they have. So, if the data is biased, it will clearly be unreliabale. Besides, financial decisions have an emotional perspective that tools and algorithms might not consider.
It’s always a good practice to balance human expertise and technology. The human element that is a financial advisor will always play a role in creating your financial portfolio.
Understand Your Biases
The exposure we have, whether good or bad, influences our financial decisions. It’s important to understand how your biases impact your investment decisions.
This may help you avoid adverse effects on your portfolio. We can use a combination of human expertise and tools to eliminate some of the biases we hold.
