Beware of biases when making financial decisions | Local company

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T&T Securities and Exchange Commission

WHEN we think of finance, many of us immediately think of complex equations, algorithms or graphs. Indeed, numbers play an important role in the financial industry, but an often overlooked and equally important aspect is the role of behavioral psychology. In this week’s article, the focus will be on the psychological aspect of the financial decision-making process, also known as bias, and how some commonly exhibited biases can affect a person’s judgment. person in making appropriate financial decisions.

What is bias and why is it dangerous?

According to investopedia.com, bias “is an illogical or irrational preference or prejudice held by an individual, which may also be unconscious.” As human beings, we are all subject to our own biases in all areas of our lives, personally, professionally and even financially. In this article, we’ll look at how these biases affect the financial aspects of our lives and how you can make smarter financial decisions by controlling these biases.

Bias is dangerous because it makes suboptimal or even terrible financial decisions justifiable, which can lead to lower financial performance. While it’s nearly impossible to completely eliminate bias from our decisions, we can minimize its effects by first becoming aware of it and then looking for alternative and/or additional reasons to base our financial decisions on.

In psychology, biases can be categorized into a myriad of broad, non-mutually exclusive groups. However, for simplicity, we can classify biases into two main types: cognitive and emotional.

Cognitive bias

Cognitive biases occur when people process and interpret information consistently incorrectly. These biases may be related to the person’s ability to remember past information, the way information is presented to them, or the level of attention or emphasis they give to selecting items of information. information. We will examine in more detail two types of cognitive biases: anchoring and confirmation biases.

• Anchoring

Anchoring bias is the tendency of people to place undue emphasis on the first piece of information (e.g. price) they are exposed to about a particular product. For example, you can buy a company’s stock at a certain price today and remain psychologically obsessed with that price as you make decisions about a future sale or purchase of that same stock.

Decisions to sell the stock solely on the basis of a price above the acquisition price – an inherently irrelevant data point – ignore any future prospects based on company fundamentals. It is indeed important to keep track of the gains or losses as a percentage of one’s investment portfolio, but one must be careful not to base one’s financial decisions completely on arbitrary anchor points, such as the purchase price. or historical averages.

• Approval

In many cases, when researching a security, investors may be presented with conflicting information that clouds the investment decision to buy, hold or sell. What is important, however, is that we keep our biases in check when conducting our research. One such bias is confirmation bias – the tendency of people to favor information that confirms their existing beliefs.

Suppose a company that you have held in your portfolio for a long time is seeing an increase in profit margin or is in the process of launching a new product. It is easy for these favorable indicators to “confirm” your decision to hold, or even invest more in securities of this company. It’s important, however, not to let these attractive features blind you to any negative news or red flags that could hamper business performance. It may be wise to be more skeptical of your initial conclusion – ask yourself questions such as whether the company took more leverage or risk to achieve this better performance or whether the company is sustainable in the medium and long term.

Emotional biases

Emotional biases, on the other hand, relate to how people feel rather than how they process information. These types of biases are not necessarily “mistakes,” but rather patterns of thinking that can be deeply rooted in personal experiences that influence a person’s decision-making and asset allocation. We will look in more detail at two types of emotional bias; specifically, regret aversion and endowment biases.

• Aversion to regret

You’ve probably heard the term “FOMO” (Fear of Missing Out), especially in conversations about the latest Ponzi, pyramid or multi-level marketing schemes. FOMO is, however, only a subsection of the larger psychological phenomenon known as regret aversion bias – the tendency of people to make decisions to avoid the pain associated with regret for not having taken said decision.

Regret-aversion bias can exist in two ways: acting to avoid the consequences of inaction (errors of omission) or not acting to avoid the consequences of action (errors of commission). For example, we might be tempted to invest in the latest initial public offering (IPO) for fear of not being able to buy that security at that price in the future. Conversely, we may be reluctant to exit a poorly performing position solely out of fear that the value of the security will rise and recover in the near future. These decisions are based on fear (rather than the actual characteristics of the investment) and are likely to lead to suboptimal portfolio performance.

• Donation

Endowment bias occurs when people place a higher value on something they already own, compared to the hypothetical value they would have placed on that same item if they did not own it. This is because people tend to become emotionally attached to things they own or have rights over. Endowment bias is very present in wealth management and is best observed when individuals inherit positions concentrated in one or a few assets, whether it be corporate stocks, luxury vehicles, a private business or real estate.

It is common for beneficiaries of estates to be emotionally attached to the assets of the previous generation and to be reluctant to liquidate their positions or to expect exorbitant sums for assets that they themselves would not pay for. In other words, if the cash equivalent of the asset were bequeathed rather than the item itself, the recipient is unlikely to subsequently use it to purchase said asset, but would instead opt for a more diversified. It is important to control the endowment bias because it can lead to a poorly constructed asset base with positions concentrated in underperforming or even useless assets.

If you are unsure, or simply lack knowledge, of how to choose an appropriate investment, you are not alone. These decisions are certainly difficult to make, and biases only make this process even more difficult. Please be sure to consult a registered investment advisor or broker who is qualified to help people make these important decisions, and remember… Beware of bias! Visit www.ttsec.org.tt for a list of registered investment advisers and broker-dealers. Next week we’ll look at other types of biases and how financial advisors can deal with clients who exhibit different types of biases.

For more information on the securities market and the role and functions of the TTSEC, please visit our website at www.ttsec.org.tt. To become a smart investor, download our investor protection app through Google Play and Apple Stores. You can also take the online investor education course on our investor education website, www.InvestUcateTT.com, and test your knowledge in our interactive investing game InvestorQuestTT at www.InvestorQuest-tt.com, and don’t forget to contact us via Facebook; Twitter, Instagram, LinkedIn or YouTube.

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