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Financial Focus

Posted August 22, 2012 in Advice Column, Pleasant Hill

If you’re like most people, you go through many complex thoughts and emotions when choosing investments. In fact, a field of study called “behavioral finance” is devoted to understanding why people make their investment decisions.

Behavioral finance researchers examine “biases” that affect people’s investment selections. As an individual investor, you, too, can benefit from understanding these biases — so you can avoid them.

Some of the key biases identified by behavioral finance experts:
    •    Overconfidence. Overconfidence leads investors to believe they know the “right times” to buy and sell investments. But if you’re constantly buying and selling, believing you are correctly “timing” the market, you may be wrong many times, and may incur more investment fees, expenses and taxes than if you simply bought quality investments and held them long term.

    •    Representativeness. If you make decisions based on preconceived ideas, you may have a bias called “representativeness.” For example, if you see that investments from a particular sector have performed particularly well in one year, you might think these types of vehicles will do just as well the next year, so you load up on them. Yet every sector will go through ups and downs, so one year’s performance cannot necessarily predict the next year’s performance. Instead of chasing “hot” investments, try to build a balanced portfolio that reflects your individual goals, risk tolerance and time horizon.

 •    Anchoring. An anchoring bias occurs when investors place too much emphasis on past performance. If you own shares of XYZ stock and the stock price hit $60 per share, you might assume XYZ will always sell for at least $60 a share. But if XYZ drops to $30 per share you might think it’s now “undervalued,” leading you to buy more shares. However, XYZ shares could have fallen due to a change in its fundamentals instead of market decline. As an informed investor, you need to work with your financial advisor to determine the causes of an investment’s decline and any actions you may need to take.

    •    Confirmation. Confirmation bias causes you to look for information that supports your reasons for choosing an investment. This can lead to faulty decision making, because you’ll end up with one-sided information. You may latch onto the positive reasons for investing in something but you may overlook the “red flags” that would cause you to think twice if you were being totally objective. So take time before making any investment decision — a quality investment will usually be as good a choice tomorrow as it is today.

Being aware of these investment biases can help you make better decisions — and in time, these decisions can make a difference as you work toward achieving your financial objectives.

This article was written by Edward Jones for use by your local Edward Jones Financial Advisor.

Information provided by Karl Ritland, Edward Jones, 1100 N. Hickory Blvd., Suite 201, Pleasant Hill, 266-8188, www.edwardjones.com.





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