Common biases that lead to bad money moves
Morningstar’s behavioral finance research team found that nearly all Americans show at least one of four common biases, and that higher levels of these biases directly correlate with worse financial outcomes compared to peers, including poorer credit scores and lower balances in savings and investing accounts. The four common biases are:
- Present bias: The tendency to prize immediate rewards over long-term goals. Someone with this bias might overpay for goods and services that bring them gratification now and neglect to put money away for retirement.
- Base rate neglect: The tendency to judge the probability of something happening based on new, easily accessible information while ignoring the original assumptions. Investors tend to overreact to new information about a stock, for instance, often overselling based on bad news or piling in based on good news.
- Overconfidence: The tendency to overestimate one’s own abilities when making financial decisions. Someone who considers themselves well-versed in cryptocurrency may be more likely to buy a new digital coin without fully considering or understanding the risks.
- Loss aversion: The tendency to be overly fearful of financial losses relative to gains. An investor displaying this behavior might hesitate to sell a flailing stock because they’re afraid to realize a loss, when it might be wiser to sell and reinvest in a more promising company.
The researchers found that low levels of bias generally went hand-in-hand with financial health. Survey respondents with low levels of present bias, for instance, were nearly three times as likely as peers to spend less than their income and more than seven times more likely to plan ahead for their future.
More biased respondents showed worse results. People with high levels of base rate neglect and overconfidence bias showed lower savings and checking balances than peers, and those with high levels of loss aversion showed lower 401(k) balances.
Video by Courtney Stith
To overcome financial biases, ‘build a money life’ that fits your priorities
The best way to avoid acting on your biases is to put “speed bumps” in place to help slow your financial decision-making, Morningstar’s researchers say. Instituting a rule requiring that you wait three days to make important financial decisions, for instance, can help ensure that you’re not making impulsive or emotional moves.
Setting rules around trading that you’ll follow regardless of market conditions can help too, they say. These could include regularly rebalancing your portfolio or selling shares of stocks after they’ve appreciated a certain amount.
It may also help to examine the reasoning behind your money moves, says behavioral finance expert Brian Portnoy, founder of Shaping Wealth and author of “The Geometry of Wealth.” People who are trying to make as much money as possible, beat the market, and outperform peers are likely looking at things the wrong way, he says.
“We’ve got our families to support, communities we want to give to, and passions we want to pursue,” he says. “If you build a money life that allows you to do all of those things, you are by definition a successful investor. It’s not a zero-sum game.”
Before you get into the nitty-gritty of financial decisions, ask yourself what’s important to you and how you can manage your money to help you get them. “Real investing starts with investing in your personal growth,” he says. “If you start with the non-financial things, you’re going to have a steering wheel or rudder that’s going to push you in the right direction.”
Having this sense of direction will also help you tune out news and advice that could tempt you into short-term moves. “If you’ve asked yourself the important questions, it’s far easier to read something and say, ‘That helps me, isn’t relevant, or that hurts me,'” he says. “If you’re evaluating what you think other people’s good ideas are without a sense of what you’re trying to accomplish, you’re probably going to end up in a bad place.”
The article “98% of Americans have at least 1 money bias, research finds, and it’s costing them” was originally published on Grow (CNBC + Acorns).