By now, you may be familiar with the advice you need to heed before taking the investing plunge: Know what your risk tolerance is, what your investing timeline looks like, and what your long-term goals are for your money.
But we’ll throw another nugget of wisdom into the mix: Know which cognitive biases you might be susceptible to.
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That's because certain psychological tendencies may lead to choices that could throw a wrench into the plans you have for your money, like owning your dream home in 10 years or living a comfortable retirement in 30 years.
Or these biases may dissuade you from investing altogether: According to BlackRock’s 2015 Global Investor Pulse Survey, 72% of Americans don’t even think of investing in the markets as a way to save for their long-term goals—and 49% say they think negatively of investing.
But if you know what your personal tendencies are, you'll be able to clear those brain blocks better—and start making more rational, versus emotional, investing decisions. Below are three of the most common cognitive biases that might inadvertently be working against you.
Brain Blocker: The Negativity Bias
Are you someone who always remembers the bad news you hear during the day but never the good? Your brain may be wired to react to negative information more strongly than to positive information.
When it comes to your money, negativity bias can manifest itself as loss aversion, or the tendency for people to feel more pain from a loss than the pleasure they feel from a gain.
This can result in becoming overly focused on market ups and downs—and feeling tempted to sell off when the markets start to drop. Loss aversion may also help explain why some people choose to stay on the sidelines and avoid investing altogether.
But remember that there will always be periods of volatility, and that, over time the markets generally tend to correct themselves. So consider setting a periodic calendar alert, perhaps quarterly or annually, to remind yourself when it's time to rebalance your portfolio according to your long-term goals—not the headlines of the moment.
Brain Blocker: The Recency Bias
You may pride yourself on having the memory of an elephant, but you may be giving more weight or credence to your short-term memories than your long-term ones.
That’s the recency bias at work; it’s a tendency to believe that what happened in the most recent past will continue to happen in the future. For example, if you flipped a coin three times in a row and kept getting heads, you may assume your next flip will be heads—even though, technically, your odds of getting heads or tails are still 50/50.
In the investing arena, recency bias occurs when people choose investments based on whatever the most recent top performers were. But past results aren’t an indication of future performance, and choosing investments for your portfolio this way is akin to driving while looking in your rearview mirror.
So rather than give too much weight to an investment’s stellar market showing over the past week, take a look at its long-term performance and do some research to see how it fits into your overall portfolio.
Brain Blocker: The Status Quo Bias
How many times have you heard the saying: “Stick to what you know”?
Probably a lot—and indeed, it could be sound advice if you’re trying to, say, start a career as a coder when you barely know how to turn your laptop on.
But when it comes to your portfolio, sticking only with what you know could mean you aren’t achieving proper diversification. One example of the status-quo bias at work is in people’s tendencies to stick with one type of asset: According to the BlackRock Global Investor Pulse, 57% of investors surveyed believe their holdings are diversified—even though 65% of their wealth is held in cash. Another example is home-country bias, or the tendency to stick to domestic investments—thereby missing out on the growth potential that may be found in international markets.
To overcome status-quo bias, remember that other old saying about not putting all (or most) of your eggs in one basket. Carefully consider venturing outside your comfort zone to build a foundation of diversified core holdings for your portfolio. Investing in exchange traded funds (ETFs) is one easy way to do this. Not only will this help spread out your investment risk, you’ll also be getting further exposure to different industries, regions and asset classes that could help bring you one step closer to achieving your long-term goals.
All investments carry some level of risk including the potential loss of principal invested.
Diversification and asset allocation may not protect against market risk or loss of principal.
LearnVest Planning Services is a registered investment adviser and subsidiary of LearnVest, Inc., that provides financial plans for its clients. Information shown is for illustrative purposes only and is not intended as investment, legal or tax planning advice. Please consult a financial adviser, attorney or tax specialist for advice specific to your financial situation. LearnVest Planning Services and any third parties listed, linked to or otherwise appearing in this message are separate and unaffiliated and are not responsible for each other’s products, services or policies. LearnVest, Inc., is wholly owned by NM Planning, LLC, a subsidiary of The Northwestern Mutual Life Insurance Company.