Making financial decisions can often be more challenging than it appears. A variety of subtle influences can cloud our judgment. Among these, behavioral biases like anchoring, loss aversion, and herd behavior have been found to shape our choices significantly. In this article, we’ll explore each of these biases and ways to counteract their influence.
Anchoring
Anchoring is similar to when a catchy tune gets stuck in your head but with numbers instead of lyrics. We tend to latch onto the first piece of information we come across and allow it to guide our future decisions. Retailers often exploit our propensity for anchoring. For example, a “sale” price alongside the “regular” price can make you perceive a product as a bargain, even if it's selling for its actual value.
Consider a situation where you purchase a stock at a specific price, and it starts to drop. Logic might dictate that selling is the prudent choice, but instead, you hang on, hoping it will rebound to the original price. Conversely, anchoring can lead to overconfidence in a stock that's performed well in the past. You may overlook the stock's actual value and hold onto it for too long due to your fixation on previous gains.
Loss Aversion
Imagine finding a $100 bill on the street. It's a pleasant surprise. Now imagine losing a $100 bill you had in your pocket. This incident would likely feel far worse. For most of us, the sting of loss is stronger than the joy of gain.
Loss aversion can result in overly cautious behavior, such as saving money instead of investing it, even though inflation may reduce its value over time. It might also lead you to hold onto losing investments, hoping for a recovery and risking more significant losses. In extreme cases, this bias can even influence career decisions, with people remaining in unfulfilling or stagnant jobs due to fear of potential loss associated with a career change.
Herd Behavior
Drawn from our instinct to follow the crowd, it can lead us to make decisions based on what others are doing rather than through our research and judgment. This tendency can lead to financial bubbles and severe market crashes.
Herd behavior often manifests during periods of market hysteria, either bullish or bearish. For instance, during a market rally, investors may be tempted to join the buying frenzy, driven by the fear of missing out. Conversely, in a market downturn, the same investors might sell off their holdings in panic just because everyone else is doing so. Getting swept up in these trends may derail your investment plan and lead to quick decisions that don't match your financial goals or risk tolerance.
Taking Action
Awareness is the first step to overcoming these biases. Recognize their presence and dig deeper in your research to avoid anchoring, manage feelings of loss aversion, and resist the pull of the herd. Also, having a clear investment plan can help mitigate these biases. By predetermining conditions for selling or buying stocks, you may be able to lessen the potential influence of your emotions on your decisions.
Lastly, it’s also worth considering working with a financial advisor. An objective outside perspective can help navigate these biases and offer strategies for dealing with them. Behavioral biases like anchoring, loss aversion, and herd behavior are inherent in human decision-making. However, you can start to counteract these biases through increased awareness, sound financial planning, and guidance from a financial professional.
1 Lewis, Ramsay. "5 Common Behavioral Biases and How They Lead Investors to Make Bad Decisions." Business Insider, 15 Aug. 2022, www.businessinsider.com/personal-finance/behavioral-biases. Accessed 7 Jun. 2023.
2 "Why Do We Buy Insurance?" The Decision Lab, 2020, thedecisionlab.com/biases/loss-aversion. Accessed 7 Jun. 2023.
3 Hayes, Adam. "Herd Instinct: Definition, Stock Market Examples, & How to Avoid." Investopedia, 7 Jul. 2022, www.investopedia.com/terms/h/herdinstinct.asp. Accessed 7 Jun. 2023.
