These 6 psychological prejudices may preserve you from constructing wealth
You’ve probably heard that you shouldn’t let your emotions guide your financial decisions.
However, this can be harder than it sounds, especially when the market is sold out.
In fact, there can be a number of psychological biases that keep you from building wealth. Because the part of our brain that enables us to imagine the future doesn’t move as fast as the part that controls emotions, explains certified financial planner Michael Finke, professor of wealth management at the American College of Financial Services.
“The emotional part of our brain has been effective at avoiding saber-toothed tigers, but it may not be as effective in a modern economy,” said Finke, whose research includes individual investor behavior.
It could result in investments being sold just to calm the emotional part of the brain instead of thinking ahead.
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The good news is that there are things you can do to overcome these prejudices.
“Knowledge is power,” said licensed marriage and family therapist Dr. George James, chief innovation officer and senior personal therapist for the nonprofit Council for Relationships. “The more you learn, the more power you have.
“Learning can be what you read, what you hear, who you connect with.”
Here are six prejudices to watch out for and how to overcome them.
1. Loss aversion
By far the strongest emotional bias, loss aversion, relates to the desire to avoid any risk that could lead to loss.
This could lead investors to sell something after the price has fallen and buy more of something that has risen.
“That can explain why many investors do worse than the market,” said Finke.
Instead, make your investment decisions with the rational part of your brain, then ignore them, he advised. Set up a system that will automatically rebalance your portfolio so that you don’t make changes based on emotion.
“When we plan for the future, we use this rational part of our brain,” said Finke. “That’s why it’s so important to think about our financial goals.”
2. Foundation effect
People tend to appreciate something more once they own it. For example, you may have inherited shares from a relative or invested in an asset that has grown in value.
“Once we’re emotionally invested in a stock, it can be difficult to sell,” said Finke.
However, if it takes up a large chunk of your portfolio, it means a lot more risk. On average, having a heavy weight on one thing won’t bring you any higher return than a well-diversified portfolio, he said.
“Another aspect of this is – if it doesn’t work, it means I’m wrong,” added James, a member of Invest in You’s Financial Wellness Council. “I want to be right, so I’ll stick it out.”
Instead, think rationally about your decisions and make sure you have the right mix of assets for your needs.
3. Fallacy of sunk costs
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This occurs when you continue to invest money in a losing project due to previous investments that you have made, such as B. Spend $ 2,000 to repair a car that keeps breaking down. You don’t want to buy a new car because you have already invested a lot of money in the vehicle.
“You shouldn’t dwell on bad decisions,” advises Finke. “Focus only on what is the best course of action in the future.”
4. Status quo bias
If you do nothing because you fear a negative outcome when the decision may be worth the risk, it is considered a status quo bias.
“You fixate on the thing that creates a negative emotion and gives a justification for not doing anything,” said Finke.
For example, you can keep a stock that has depreciated because you don’t want to take a loss.
Instead, think rationally about price and how it compares to expected future prices and dividends. Also, remember that taking losses has tax benefits when it makes sense to invest smartly. Selling assets at a loss makes up some of the profits you made – which should reduce the amount of taxes you have to pay.
Just because everyone is buying a stock doesn’t mean it’s right for you. Still, people feel more secure when they follow the crowd.
The recent surge in so-called meme stocks like AMC Entertainment and GameStop is a case in point. Individual investors piled into the stocks after being prompted to do so on social media, and many may have lost money amid the volatility.
“You hear stories about people who made money with very risky investments and you feel like you’ve missed the boat,” said Finke.
“This fear of regret leads many people to make investment decisions that are not wise.”