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As an investor, one of the greatest tools you have at your disposal is your mind. But that tool can often get in the way of making rational decisions, particularly when it comes to investing.
Emotions are powerful and whether we mean for them to or not, they can greatly influence how investing decisions are made. Sometimes, they lead you down the right investment path but they can also lead you astray.
Perhaps that’s why the famous Warren Buffet cautions fellow investors to “be fearful when others are greedy and be greedy when others are fearful.”
Enter behavioral finance, a practice that applies behavioral and cognitive psychological theory to explain why people make irrational financial decisions.
From this field of study, we know there are many common behaviors that influence how people make investment decisions. By understanding those tendencies, listed below, investors may find it easier to take the emotion out of investing and make more rational decisions.
Overconfidence — The tendency people have to be confident in their decisions when they are unaware of the information they do not know.
Hindsight bias — A side effect of overconfidence in which individuals view events from the past as predictable. This also leads to individuals viewing their past predictions as being more accurate than they actually were.
Illusion of control — The belief that you have control or influence over certain outcomes. People who think like this often believe that skill has more effect on an event’s outcome, than chance.
Anchoring and adjustment — The way individuals estimate probabilities. It is common for individuals to anchor to the purchase price, making adjusting to new information difficult.
Loss aversion — A result of anchoring and adjustment that makes investors believe it’s favorable to avoid loss rather than to achieve gains.
Regret aversion — The inclination to avoid making decisions when you perceive that it may not end well.
Herd mentality — Making decisions based on what peers and popular trends suggest you should do.
Narrow framing — What happens when investors isolate each portfolio holding, rather than viewing the context of the entire portfolio. This is the enemy of constructing a diversified portfolio.
The common behaviors are admittedly difficult to avoid, but awareness is key. When making investment decisions, work with a financial advisor on creating an investment philosophy and process, this can help you focus on your long-term goals and make it easier to be a non-emotional investor.
This article is provided by RBC Wealth Management on behalf of Pamela J. Carty, AWM, a Financial Advisor at RBC Wealth Management, and may not be exclusive to this publication. The information included in this article is not intended to be used as the primary basis for making investment decisions. RBC Wealth Management does not endorse this organization or publication. Consult your investment professional for additional information and guidance.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC
