On this episode of A Wiser Retirement Podcast, Casey Smith, Matthews Barnett, CFP®, ChFC®, CLU® and Brad Lyons, CFP® talk about behavioral finance and the impact that your behavior can have on your investment portfolio. They talk about various biases, such as conservatism, overconfidence, herd behavior, and loss aversion. They tell you how to overcome bias and set yourself up for success.
This includes the psychology of finance, sociology, and economy. It helps us understand how we behave and how we have an emotional bias toward decision making. “Psychology of Money” by Morgan Housel is a quick read if you find this topic interesting. Money is a very emotional thing, so it is very important to understand your decision making when it comes to finance.
Types of Biases: Conservatism, Overconfidence, Herd Behavior, Conformation, Loss Aversion
Conservatism bias entails sticking to information that you are comfortable with. It can also include relying too heavily on existing data verses new data, only sticking to markets that one knows very well, or solely investing in domestic markets. Overconfidence bias is something we typically see in younger people or from people who know someone in the financial services industry that is giving them tips. Herd behavior is when people are chasing the herd mentality, because they don’t want to miss out on what is trendy to invest in. Conformation bias is when someone has a thought about something and then finds an article to support that thought. Loss aversion means that people feel twice as bad about a dollar lost as the joy felt with a dollar earned. That goes back to just trying to avoid losses because it hurts more than what you’re actually gaining.
The Behavior Gap
There’s the rate of return the market gives you, and then there’s your actual rate of return. That gap between the two is known as the behavior gap. That gap is why people often need professional help with their portfolio, so that they can stay the course, and focus on their goals.
Setting Yourself Up for Success
You have to set yourself up for success, so that a bear market will not steal your future. You want to build a buffer between you and a portfolio, so that you don’t do something stupid. Biases can often inhibit you from making rational decisions. The job of a good advisor is to help you understand and recognize that bias and then show you the likely result that will occur if you continue with that behavior or bias.
How Do We Overcome Biases?
There isn’t necessarily a bias proof portfolio. One of the best ways to protect a portfolio from you is to have enough cash between you and the portfolio, so that you don’t have to go to your portfolio in times of an emergency. This prevents you from overreacting if the market behaves poorly. The reality is, a well constructed, diversified portfolio addresses almost all biases.
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