This is the second in a three-part series where we are examining biases in financial thinking.  We learned in Part 1 that the tendency to make inaccurate judgments and misinterpretations based on emotional and social influences can affect the financial thought processes.


Discussion Based on Emotional Bias Continued

Last week we examined the first of the emotional biases that may cause investors to be prone to buying and selling stocks more frequently.  We know that biases can develop from a variety of sources: your childhood, family, personal experiences, societal influences, and more. These next sections focus on the remaining group of emotional-based biases and introduce social factors:

  • Overconfidence effect can be a costly downfall for investors. In this case, investors overestimate their ability to pick stocks with the best returns and the best times to buy them. Many investors have been surprised when the stock market doesn’t play out as anticipated.
  • Illusion of control bias, similar to overconfidence, this is the tendency to think you have more control over investment outcomes than you really do. As a result, you underestimate the risks involved in your investments. Many of us have been guilty of believing our skills and decisions led to success, when investment turns out well.
  • Endowment effect is the tendency to demand much more to sell an object than you would be willing to pay to buy it. This is due to the pain associated with giving up something, especially if it has performed well in the past – which is not necessarily indicative of its success in the future.
  • Familiarity bias is a preference to invest your money in something familiar. They invest in their own company, state, or country because they are more comfortable with it, and therefore feel that the decision is “safer.”

Biases Based on Social Factors

Now let’s take a look at social influences that more can lead to biases affecting financial decision-making:

  • Conformity bias (or bandwagon effect) is the tendency to behave similar to others in a group, regardless of whether it goes against your own judgment, even if you know that investing in a certain way may not have great results.  As more people adopt an idea, the likelihood of the bandwagon effect increases.
  • Availability bias is the tendency to weigh decisions more heavily toward recent information obtained from the media. For example, the latest news about a stock can disproportionately affect the decision to buy that stock.

Next week, we will conclude this series with a review of cognitive biases that sway some investors. This important information will provide insight into the way the mind processes complex data.

Remember, we are here to help you avoid making mistakes fueled by biases.  So if you have any questions, please call or email our office to schedule an appointment.

 

*Bruce Miller is an Investment Adviser Representative of Arista Wealth Management, LLC, a Registered Investment Advise

Bruce Miller condensed this article originally produced by Advicent Solutions, an entity unrelated to Arista Wealth Management.  The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties.  Arista Wealth does not provide tax or legal advice.  You are encouraged to consult with your tax advisor or attorney regarding specific tax issues.
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