- Investors don’t need to fully eliminate emotions or bias from their investment decisions, but they do need to manage them.
- Understanding your own biases is a critical first step toward ensuring they don’t derail your portfolio goals.
- Using mental models provides an objective way to evaluate reactions to market events and opportunities.
Understanding your biases
- Anchoring or confirmation: This refers to a first impression or preconceived notion that’s hard to shake. For example, perhaps the market dropped after the pandemic, and now you’re convinced there’s more decline to come.
- Loss aversion: Investors don’t want to sell a losing investment because then they have to admit they made a poor decision that cost them money.
- Disposition effect: With this bias, you deem investments “winners” or “losers” and either hold onto them for too long or sell too early based on your initial assessment.
- Hindsight bias: In this case, investors overestimate their accuracy in predicting market events and then assume that other predictions they have about the market are correct.
- Familiarity: An investor is overly comfortable with a specific investment strategy or sector, leading to an increased concentration of that sector or overreliance on that strategy within their portfolio.
- Self-attribution: Investors with this bias give themselves credit for successful investment decisions and attribute poor outcomes to external events.
The power of knowing your investment goals
Recognizing your biases is the first step toward developing tools to make them work in your favor. Next, you must define your financial goals and connect them with a strategy. For example, you may aim to save a specific sum for retirement or to fund your children’s higher education.
Each goal should include a defined timeline that will inform the required strategy and risk level. And each goal should be anchored into a personal “why.” The latter refers to the deeper purpose of those funds; perhaps they’re enabling you to pursue a business endeavor that matches your passion or leave a financial legacy to your family.
The timeline and the “why” create a context for investment decisions and a backstop for your biases. If a bias is working against your goal, then it merits review. Indeed, remaining humble enough to question your reactions, correct mistakes and even accept some losses (as part of a sound strategy) is an essential part of managing your biases.
How mental models help
Investors may be understandably overwhelmed by all the factors that impact an investment decision. Mental models provide a shortcut for addressing biases and achieving your investment goals in the process. While a bias reflects an emotional response to events in the market, a mental model provides the opposite: an objective external framework for evaluating investment decisions.
Using various mental models can help make sense of such patterns. And they don’t need to be complicated. For instance, you may opt to invest in companies widely owned by insiders; this reveals confidence in the business by the people running it. Another mental model is to invest with three buckets in mind:
- Insurance or safety: This is money you need to protect your standard of living and help ensure you can pay for expected expenses. The strategy or products that serve this purpose can include cash, annuities or traditional insurance.
- Maintenance: These funds are dedicated to helping you keep pace with — or beat — inflation so that you can afford your lifestyle in the future. Investments here could be equities, fixed income or even alternative investments.
- Fun: This money is dedicated to helping you further “fun” goals, such as buying a boat or taking a big trip. These investments tend to be higher risk and reward, such as real estate, art collections or concentrated stock positions.
As with most aspects of investing, you want diversity in your mental models. Select more than one to use and explore others as they arise. Most importantly, use them routinely.
The role of a wealth advisor
Recognizing your investment biases, defining your goals and employing mental models are effective ways to ensure that your emotions aren’t driving your investment strategy. However, you can’t rely on introspection alone to achieve your goals.
The investment process depends on external analysis and expertise, which is where a trusted wealth advisor comes into play. A wealth advisor can provide detailed strategies for achieving your objectives and monitor your progress toward them. The combination of knowing yourself and a trusted advisor who also knows you can help keep your emotions in check and your portfolio on track toward achieving your goals.
Contact your First Republic team to learn about additional tools for maintaining investment discipline during up and down markets.
This document is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein.
The strategies mentioned in this article may have tax and legal consequences; therefore, you should consult your own attorneys and/or tax advisors to understand the tax and legal consequences of any strategies mentioned in this document.
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