Cognitive biases are present in everyone’s daily life and affect various aspects of life, including financial ones. There are different cognitive biases and it is important to know about them to prevent them from leading to wrong investments and losses.
Mental automatisms, from which prejudices are generated that most often lead to wrong choices: cognitive biases are mental distortions that we usually put into practice when assessing situations and making decisions. Including those on financial matters.
The problem is that these biases, literally prejudices, lead to the creation of a subjective and untrue view of reality, which tends to agree with our beliefs and experiences. Thus leading us to distorted evaluations and often wrong choices.
When faced with a decision, such as an investment choice, we have two options. Namely, to carry out a rational analysis or to use a more intuitive and rapid approach that will be based on past experiences and thus on our biases.
This second possibility is obviously a shortcut, which we often use in everyday life because it saves us time. But in more complex choices, such as financial ones, it may turn out to be wrong, because we are not always in control of what happens and what will happen will not always correspond exactly to our beliefs.
Biases in financial choices
Here are some of the main biases that are often put into practice in financial choices.
- Confirmation bias: this is the tendency to more readily accept information and news that confirms one of our beliefs. In fact, we tend to accept even erroneous information as long as it supports our thesis;
- Availability bias: this occurs when an event experienced in a recent moment distorts our view of reality. The result is that we convince ourselves that the event in question is much more likely than it really is. For example, if a friend has just told us that he made a lot of money with cryptocurrencies, we may be led to choose to make the same investment with the belief that the same thing will happen to us, without considering the risks involved;
- Familiarity bias: it leads investors to prefer what they know or feel close to, such as national government bonds or investments already made by parents or friends. This type of preference generates a lack of diversification of investments in the portfolio and thus an overexposure to specific geographical areas or financial instruments. In fact, it is not necessarily the case that choices made by people who are close to us or who give us the impression of being safe because we know them are really the best solution;
- Status quo bias: it consists in preferring the situation one is in by avoiding any kind of change. One prefers, for example, to keep one’s portfolio as it is, despite having made bad choices or incurred high costs, out of a sort of fear of the unknown;
- Loss aversion bias: this occurs when, despite knowing that the portfolio is suffering losses, one ends up keeping it as it is for fear of incurring greater losses by making changes.
How to manage bias when investing
The first step is to be aware of the existence of cognitive biases and how they work.
Then it can be helpful to get an advisor to help you choose investments, so that you can make an impartial and lucid assessment to find the best possible investment solution based on your needs, risk appetite and goals.
Read also: Financial risk profile: what is it and what it depends on