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The Role of Our Biases in Investing

Every day we make thousands of decisions. Some big, others small. Some decisions we are consciously aware of—while others we make instinctively and automatically, often based on our “gut” or cognitive biases.

A cognitive bias is an instinctual response or belief that we have. Most of these responses have developed over time to provide our brains with “mental shortcuts” to process information. Otherwise, we wouldn’t be able to function if we had to painstakingly evaluate every decision or action.

These automatic responses are often correct and our biases are harmless. However, when it comes to investing, biases may negatively impact our decision-making.

Here is a list of six common biases to be aware of when it comes to money and investments:

  1. Overconfidence Bias1 is our belief that our abilities are greater than they are. When asked to rate themselves on abilities, most people consider themselves above average.
  2. Authority Bias2 is our tendency to adopt the views of “experts” without question and to discredit our beliefs if they differ.
  3. Confirmation Bias3 occurs when we look for information that confirms what we believe to be true. We are much more likely to look for confirming data than to look for evidence that contradicts our beliefs.
  4. The Gambler’s Fallacy4 is our belief that what has happened in the past will happen again in the future. This is closely related to Recency Bias, which is our tendency to place more importance on newer information and discount older data.
  5. Conservatism Bias5 manifests itself when we are slow to change our beliefs, even in the face of proof that we’re wrong. This is also the Sunk Cost Fallacy, or our tendency to hold on to our investments rather than throw in the towel.
  6. The Narrative Fallacy6 exists because we prefer stories over facts. You’ve likely heard the phrase, “Never let the facts get in the way of a good story.” We tend to look at data and construct a story that explains it, but that doesn’t mean that the story we create is true.

It’s important to understand and be aware of these biases as they can strongly sway how you make decisions, especially when it comes to investing. A common piece of advice in the investment world is to “take the emotion out of your decision-making” which can help to avoid many of these cognitive biases.

When making decisions about your money, know that you are not alone. At Jemma Financial, we can help remove the biases you may have about investing so that you can meet your financial goals.

Sources:
1Parker, T. 4 Behavioral Biases And How To Avoid Them. https://www.investopedia.com/articles/investing/050813/4-behavioral-biases-and-how-avoid-them.asp
2Wikipedia. 2018, March 7. Authority Bias. https://en.wikipedia.org/wiki/Authority_bias
3Wikipedia. 2018, May 31. Confirmation Bias. https://en.wikipedia.org/wiki/Confirmation_bias
4Investopedia. Gambler’s Fallacy/Monte Carlo Fallacy. https://www.investopedia.com/terms/g/gamblersfallacy.asp
5Wikipedia. 2018, January 9. Conservatism. https://en.wikipedia.org/wiki/Conservatism_(belief_revision)
6 Marotta, D. J. 2016, October 15. The Narrative Fallacy. https://www.forbes.com/sites/davidmarotta/2016/10/15/the-narrative-fallacy/#307550331bf3

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