Overcoming Human Biases in Investing: 3 Effective Steps

Key Takeaways

We’re all human, with common emotions, traits and tendencies—although we express them in our own unique way. According to behavioral investing experts, everyone has underlying biases that can affect their decisions about money.

How do you keep unconscious biases from interfering with your financial future? Start with these three steps.

Step 1: Appreciate Your Humanity and Recognize Biases

Start with a simple yet profound premise: acknowledge the reality of human behavior. It’s important to be aware of your own tendencies.

For example, being loss-averse (something that affects many of us when markets are down) can cause problems in the long run. You might get upset at the idea of a small loss and not very excited at the idea of a bigger gain. But if you filter decisions through a lens of loss aversion, you can miss out on opportunities.

Step 2: Create a Checklist for Better Decision Making

Create a list of what you need to consider before you decide on a course of action. Let it serve as a reminder of what you’re working toward. Include things such as:

• What are my long-term goals?

• Does this action threaten a long-term goal?

• What do I want or what do I need now?

• What are the alternatives?

• What are the costs?

• What are the benefits?

A focused list of considerations can help you sort through your options and make a more informed decision about your future.

Step 3: Develop a Precommitment Strategy for Investment Success

Do you pay bills online automatically each month? What about making automatic contributions from your paycheck to a savings account or 401(k) plan? These are precommitment strategies—good money decisions that you don’t have to remake each month.

You can also use precommitment strategies to help keep yourself on track. Consider automatically reviewing your portfolio by setting an annual appointment with yourself or a financial advisor. If one part of your portfolio has done well over the past year while another has lagged, the discipline of rebalancing may reduce the risk that you’re buying high and selling low based on emotions.

Pre-commitment strategies are one of the best defenses against the negative effects of psychological biases. Committing to sound money practices today can help prevent your future self from acting in ways that sabotage your goals.

Understanding Behavioral Investing and Human Biases

While no one can completely avoid behavioral biases, being aware of them can help you make better decisions. Understand how these biases can impact you, use the ones that may benefit you, and watch out for those that can get in your way.