Think Before You Invest
Humans are creatures of habit with default behaviors, tendencies, and emotions that often work against them. Take, for example, relationships. In relationships, partners often fall victim to two negative behavioral biases that impact the union: confirmation bias and negativity bias.
Confirmation bias is a cognitive distortion that causes us to selectively search for evidence to support what we believe to be true. It’s a tendency to pursue and believe facts that “prove” what we already suspect or believe to be true. Confirmation bias affects our beliefs about ourselves, the world, and relationships. Jon Beaty, 2 Biases That May Be Hurting Your Relationship, gottman.com.
For example, suppose a wife believes that her husband is financially irresponsible. In that case, she will perceive every financial decision of his as being irresponsible – whether they are or are not – to fit his actions within that preconceived perception.
Negativity bias is our tendency to give greater attention and weight to negative information.
For example, a wife could come home one day expressing her excitement to her husband about getting a new job that pays $2 more an hour. The job will add five minutes each way to the commute, however. A husband influenced by negativity bias will focus more on the additional commute time than his wife’s higher pay and excitement.
In investing, investors are similarly influenced by unconscious biases and inherent aversions that negatively influence their investment decisions in his book, Stop. Think. Invest., author Michael Bailey explores these biases in the context of behavioral economics and how emotions and life experiences influence people’s investment decision-making.
As humans, we each have a set of biases and fears that inform our decision-making – even as we’re aware of their influence over us and our daily decisions. Behavioral economics study how the social, psychological, and emotional facets of human nature play into the field of economics and investing. It represents a combination of cognitive behavioral factors that should be recognized to steer our investment decision-making instead of letting our biases and inherent emotions rule our choices.
To avoid the biases that influence bad investment choices, the first step is to Stop. You first have to recognize the most common biases that inform investor decision making and how those biases often lead to bad choices. Two of the most common biases are the availability and risk aversion biases.
The availability bias is our tendency to treat readily available information as more important, reliable, and relevant than information that is harder to come by. Availability bias says investors will invest in what’s easy and what’s in their faces.
For example, nothing is more “available” than stocks or crypto in investing. With free trading platforms like Robinhood, novice investors can be up and running within minutes. And with stocks and crypto getting all the love on social media and generating all the internet buzz, availability bias explains why these two assets are so popular with investors.
Risk aversion says that the risk of loss far outweighs any potential gain. The evidence suggests that we feel losses at least two to three times as strong as an equivalent gain. In other words, people have an inherent aversion to risk.
For example, given a choice between receiving a five-dollar refund, no questions asked, or a ten-dollar refund that requires a stressful conversation with customer service, most people will choose the five dollars because it’s an easy and safe bet. paminy.com. The problem with risk aversion is that investors tend to go with the safe bet and are not open to other options.
So how to overcome behavioral biases? Think.
In his book Nudge, author and Nobel Prize-winning economist Richard Thaler suggests overcoming biases through a combination of libertarianism and paternalism. In this context, being libertarian means being open-minded – open to all ideas and free of opinions or biases that might blind you from the perfect investment opportunity. However, after you’ve looked at things with an open mind, you’ll need to narrow them down by exerting a certain amount of paternalism. That entails using your knowledge and exerting your influence to guide the selection process in a certain direction. paminy.com
To make the best investment decisions, Stop. Think. Invest.
Stop to think about what investments your natural tendencies and biases would steer you towards. Think about alternatives to what the masses tend to go with. Consider other options, weigh those options, then put some thought, analysis, and due diligence into your final decision.
Once you’ve thought, don’t hesitate to invest. Don’t let the fear of loss prevent you from investing in something you’ve already determined would be in your best interest. In other words, take the plunge.
Michael Foley, president and CEO of Humabilt Capital, oversees the entitlement process, funding, and operations for Humabuilt Capital. Mr. Foley has been a full-time real estate investor since 1995 during which time he has developed hundreds of single-family homes, townhomes, condominiums, and apartments. Mr. Foley started his investment ventures in Long Beach, California, and has expanded to Apex and Durham North Carolina. Mr. Foley is a graduate of the University of California at San Diego.