Individual investors often follow strategies that are unknowingly fraught with bias. In fact, a scenario as simple as basing an investment decision on a past experience could be an example. There are many ways bias can make its way into your portfolio, and it’s crucial to identify where it’s taking control so it doesn’t negatively impact your financial goals.
While this is far from an exhaustive list, here are three common ways bias might be affecting your investments.
1. Herd Mentality
Simply put, this is the desire to do what others do. A great example from today is the realm of Bitcoin and cryptocurrencies, where herd mentality leads some folks to make risky investments they don’t fully understand. In order to avoid this bias, it’s crucial to understand that investments should suit the investor’s goals. Every investment portfolio is different, and yours should cater to your needs without taking on too much risk. What seems to work for some is unlikely to work for all.
2. Loss Aversion
Loss aversion is the bias that leads investors to miss out on gains so they can avoid losses, whether real or perceived. The market downturn due to COVID-19 stands out as a period of time when loss aversion led to disastrous outcomes for some investors. Those influenced by this bias may have sold stocks during the decline in an effort to minimize losses. Furthermore, they may have held excessive balances in cash, missing out on market recovery due to fear of loss. Unfortunately, the opposite approach would likely have been more beneficial, as stocks held or purchased during the downturn, generally have recovered and grown to new highs.
Hindsight is one of the most prevalent investing biases. If at any point you’ve thought, “I should have seen that coming,” when in fact the circumstance was unpredictable, you’ve experienced hindsight bias. This way of thinking was quite common during and after the financial crisis of 2007–2008, and though it may not sound nefarious, this bias can regularly influence decisions. No one has a crystal ball and individual investors should caution themselves against thinking they can predict the future, or potentially face costly mistakes.
Monitoring each potential bias can feel exhausting, but don’t lose hope. Fortunately, this is where an objective investment strategy can help. Objectivity is one of the strongest tools to combat bias in investment management, as it leaves no room for bias to influence decisions. At Rodgers & Associates, we believe this is one of the key benefits investors receive working with an adviser. Remain objective, and don’t let bias determine your future.