When making financial decisions, we often like to believe that we are guided solely by logic, analysis, and numbers. However, the truth is that our emotions play a significant role in how we manage and invest our money.
Emotional biases are ingrained in the psychology of investors and can be very hard to overcome. However, understanding these biases and how they impact our financial decisions can help us make more informed, rational choices that align with our long-term goals.
The efficient market hypothesis suggests that asset prices are efficiently valued to reflect all publicly available information. However, this assumes that all investors are rational and acting logically, which is not always the case.
The first emotional bias we will look at is “Loss Aversion”. Loss Aversion is when the fear of losing money starts to drive your investment decisions. Research shows that the emotional impact of losing money is twice as powerful as the joy we experience when achieving a similar gain. This bias often leads to investors holding onto declining investments far longer than a rational investor would or selling good investments at the first sight of a loss.
Overconfidence is another psychological bias that can interfere with your investment strategy, by creating an illusion of control. Overconfidence bias occurs when investors overestimate their investment knowledge and abilities leading to poor decisions. An abundance of online information that is not always accurate can exacerbate this psychological bias, leading to risky decisions such as excessive trading, concentration in a few stocks, and ignoring basic diversification principles.
The last emotional bias is Recency Bias, where investors give bias to recent events and information rather than looking at the full picture and making informed decisions based on historical patterns. As a result, this can lead to investors following recent trends buying into market bubbles, and selling into bear markets.
In conclusion; whilst the efficient market hypothesis assumes that all investors are rational, we know in reality this is far from true. Loss Aversion, Overconfidence, and recency bias are just a few examples of how emotions can cloud judgement and lead to poor financial decisions.
By understanding these biases, we can take steps to mitigate their impact and make more rational investment decisions.
Financial advisers can be crucial in helping clients navigate these biases. By providing regular reviews and guidance, advisers can help clients stay focused on their long-term investment goals. They can help them avoid impulsive decision-making on short-term market movements and, instead, stick to a proven investment strategy that is backed up by research and specialist investment knowledge.
