Psychology plays a key role in investing, and your biases can have an impact on how you choose to invest your money. Understanding investor emotional biases and strategies can help you make more informed decisions when you’re ready to expand or diversify your portfolio. We’ll explore the psychology of investing and just how it can change the way you look at your financial strategy.
The field of behavioral finance explores psychology and how it can affect the financial decisions of investors. Psychologists look at biases, including some you may have heard of in other contexts, such as confirmation bias, to better understand how these preconceptions can influence behaviors. By learning about biases, it can be easier to learn how to overcome them. We’ll cover a couple of key biases here to give you a better understanding.
Confirmation bias occurs when people seek out information that aligns with existing beliefs. For investors, this might mean only seeking out certain types of companies or of investments that fit a preconceived narrative. For example, an investor might hear that a specific stock is going to outperform the rest due to a recent invention. He or she may subconsciously choose to only read articles and watch news segments that confirm the outlook for this stock, and then will finally invest only in this particular stock. The investor has not looked for any information that takes an objective look at the investment, resulting in a narrow focus and potential risk to his or her portfolio.
Investors can overcome this type of bias by actively seeking out contrary opinions about different investments. By looking at both the pros and cons and weighing them equally, you can help avoid confirmation bias and make informed decisions.
Loss aversion is perhaps one of the easiest biases to understand, though it isn’t always easy to avoid. This concept covers the idea that some investors may be so afraid of losses that they avoid taking risks. This may result in holding onto losing investments for too long in the hopes of a bounce back or selling winning investments too soon to avoid a potential crash. In both situations, the individual makes an irrational or uninformed decision simply to avoid the stress of a potential loss.
Creating a diverse portfolio can help you avoid loss aversion. A diverse, balanced portfolio gives you the freedom to let winning investments continue to build or grow, as your other investments can act as a hedge should that winner start to lose ground. You can also work with a financial advisor to explore specific portfolio strategies, such as index investing or factor investing. Another option is to add specific types of long-term investments to your portfolio to create a targeted approach to stock market volatility. Real estate investments, for example, can help diversify your portfolio while offering protection against both volatility and inflation.
While there are specific strategies to employ for different biases as outlined above, there are also some general strategies you can use to overcome a range of biases and investment decision emotional factors. You can employ the following strategies to take a more centered approach toward building wealth.
The first step to overcoming biases is to recognize they exist. Take some time to analyze how you look at your current investments and how you approach picking new ones. Are you fully researching the different options available to you by weighing the pros and cons? Is there data to back up the decisions you make? Understanding how you come to your decisions can help you identify your biases so you can create a plan to avoid them.
Creating long-term goals may help you stay focused on the end result. Loss aversion and confirmation bias may narrow your view of investments so you’re only looking at short-term results. You may break down all your long-term goals, such as retirement, college savings, and even dream vacations so you’re always keeping your eye on the prize. Long-term investments, such as real estate, with less liquidity, can prevent you from making rash decisions based on your biases, and they can also help you create a more diverse portfolio to minimize risks.
Seeking professional advice makes it easier to overcome your biases. A financial advisor can help you identify different investments to add to your portfolio and provide you with risk assessments and analyses to better inform your financial moves. Your advisor acts as an objective third party who can potentially identify when biases are impacting your decision making. As always, we recommend discussing investments with a professional before making any decisions. DiversyFund is not a financial advisor and is not acting in such capacity.
Everyone is susceptible to biases, whether we realize it or not. Taking the time to understand biases and how they impact financial decisions is the first step to helping ensure they don’t play a key role in your decision-making process. Whether you’re a first-time investor just learning the ropes or you’re an accredited investor looking to invest in a single-asset real estate offering, knowing more about how the psychology of investing works can give you more insight as you work to build wealth. To learn more about DiversyFund’s offerings for both accredited and non-accredited investors, click here.