Much of financial planning revolves around your retirement planning strategy – a strategy that very likely involves investing. On the surface, investing may seem to be all about facts and figures, like principles and interest rates. However, there’s always a human element that shouldn’t be overlooked. In fact, an entire domain of psychology known as behavioral finance shows we are all susceptible to cognitive biases and emotional influences that impact self-control, risk tolerance, and rational behavior.
In this article, we’ll explore two of the most common cognitive biases – herd behavior and overconfidence – and how they could be sabotaging your financial plans. Once you are aware of them, you can combat these negative behaviors and move beyond them for greater financial security in retirement.
Cognitive Bias #1 – Herd Behavior
You may consider yourself an independent thinker who cannot be influenced by those around you. However, have you ever been driving and realized that you’re driving at the same speed as those around you? If you’ve ever picked up the pace to “go with the flow of traffic,” you’ve exhibited herd behavior. In the world of investing, herd behavior is common. An example would be purchasing a stock that appears to be on a winning streak, despite financial advisors cautioning against it and the stock’s price is high relative to earnings. Of course, the market will inevitably shift, and you’ll find yourself trying to offload this investment when the market declines, even if it means selling the stock at a loss.
You can see how herd behavior creates a reactive approach to investing, and it will nearly always leave you a step behind – the driving equivalent of switching to the fast lane only to be immediately slowed down and passed by your previous lane of traffic. Rather than creating a consistent retirement investing strategy, herd investors are always chasing the ”fast lane.” You can avoid this troubling cycle by focusing on your own financial goals and plans. What are the long-term projections for your investments and is your portfolio diversified enough to meet your personal risk tolerance but still allow for growth? These are the moves that will truly help you build wealth from your investments over time.
We’re all susceptible to cognitive biases simply because we’re human. You may be exhibiting herd behavior if you:
- Frequently move money around in your accounts and investments during a down market (bear market)
- Tend to purchase or add more money to your accounts and investments in an up market (bull market)
- React to news about the market – whether up or down – by adjusting your portfolio
- Ignore or forget your overall financial plan by focusing on the “here and now” or find yourself chasing “the next big thing”
Many investors can easily recognize this behavior in others but have a difficult time seeing it in their own actions. If you see yourself handling your investment portfolio in the ways mentioned above, remind yourself to pause before making a move and ask yourself if it’s rational.
Cognitive Bias #2 – Overconfidence
Our emotions absolutely play into common biases. When the market is up, so are the emotions of many investors. After all, watching your portfolio perform well can leave you feeling confident and satisfied. It’s a great feeling while it lasts, but it may inflate your confidence in your own financial acumen. This is dangerous territory if it propels you to take on riskier investments than you normally would.
Of course, any winning streak is uncertain and is likely to end at some point. A downturn in the market could cause major losses if you haven’t been prudent about diversifying your portfolio, which can shield your retirement investments from asset-specific risk. If you’ve gotten over-confident and shifted all your money into high-risk, high-return investments in one industry and that industry takes a hit, your money will take a hit too. It’s clear how overconfidence can be one of the most dangerous cognitive biases for investors.
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How can you overcome it? Don’t let a bull market compromise your decision-making. Instead, always consider your investment portfolio as a whole, and be sure you’re properly diversified to mitigate risks. Never rely on one “superstar” in your portfolio because it could suddenly stop performing at any time. The graveyard of the stock market is filled with companies that were deemed “too big to fail.” When considering high-risk, high-return investment opportunities, be sure you are comfortable with any losses they could bring, and how those losses would impact your retirement nest egg.
If you’re worried about overconfidence impacting your investment decisions, here are a few clues it may be happening:
- You feel overwhelmingly excited when your portfolio is performing well
- You ignore the potential consequences of losses in your portfolio while in a bull market
- You disregard financial advisors and other experts when they encourage caution or diversification
If this sounds like you, don’t despair. It’s never too late to take measures to overcome cognitive biases and make certain your overconfidence doesn’t get the best of you.
Final Thoughts on Cognitive Biases and Your Financial Plan
Pensions have been falling by the wayside over the last several decades, and Social Security has a bit of an uncertain future for the next generation of retirees. This means you will likely need to rely on investments to fund your retirement – and it is critical to avoid the damaging cognitive biases that could sabotage your retirement nest egg.
If you find yourself exhibiting some of the behaviors mentioned above, you’re not alone. You’re human, after all! Acknowledge cognitive biases when you see them at play and work to address your unconscious behavior as best you can. And, if you’d like professional guidance, we can help.
At Wade Financial Advisory, we offer personalized financial planning and wealth management services in Silicon Valley and beyond. As fee-only planners and fiduciaries, we receive no commissions or referral fees for any of the solutions we recommend, ensuring that our advice is unbiased and focused solely on our clients’ best interests. If you’d like to discuss how we can serve you, please schedule a conversation with us today.