How to Avoid Cognitive Investing Biases on the Road to Financial Independence

Cognitive Investment Biases

In celebration of Independence Day, your Money Guys are talking about how our emotions can interfere with achieving financial independence.

We all know that being invested in the stock market puts our money at risk, which can cause a roller coaster of emotions at times. When the market is up, we’re happy, and when it’s down, we’re depressed and anxious.

Letting your emotions influence your financial decisions, especially when it comes to your investments, is a bad idea. How can we push our emotions aside so they don’t cause us to make grave mistakes with our portfolio?

Brian and Bo give you the answers in this episode, and discuss 15 cognitive investing biases to avoid on the road to financial independence.

Don’t Let Your Brain Hold You Back When it Comes to Money

Rick Edelman’s book, “The Truth About Money,” reviews the cognitive biases investors are most at risk for, and Brian goes through each in detail. He provides insightful examples so you can recognize when your emotions might be controlling your investment decisions.

The first step in being able to avoid these biases is to simply be aware of them. All too often, we get caught up in our thoughts and rationality goes out the window. You don’t want to play around with your emotions or your money, especially when it comes to growing your wealth to reach financial independence.

Here are 15 cognitive biases to stay away from as an investor.

 

  • Intuition Bias: Do you rely on your gut to make investment decisions? It goes without saying that’s a big mistake!
  • Mental Accounting Bias: This is when we treat our money differently depending on where we’ve mentally allocated it.
  • Compartmentalizing Bias: If you have multiple investment accounts, are you factoring in the investments you’re holding in all of them when figuring out what to invest in? Or are you viewing each as a separate account? You shouldn’t compartmentalize your investments.
  • Pattern Recognition Bias: Many of us are guilty of seeking out patterns that don’t exist. This is why “past performance does not guarantee future results” exists.
  • Recency Bias: We have a tendency to focus on current events, and this might cause us to base future predictions on how the present is going.
  • Proud Papa Bias: This occurs when we fall in love with our investments, or when we have a personal interest in seeing a stock do well.
  • Optimism Bias: This is when we think bad things only happen to others – not us – which causes us to be overconfident in our investments and to underestimate risks.
  • Illusion of Control Bias: If you think your actions control events, you’re guilty of this one. Just because you purchase a stock doesn’t mean it will perform well.
  • Pessimism Bias: The opposite of optimism bias, this is when we second-guess all of our investment decisions and can’t take action.
  • Catastrophe Bias: A combination of the recency and pessimism biases, this occurs when we think another recession is just around the corner, and hold ourselves back from entering the market because of that belief.
  • Regret Aversion Bias: Have you ever made such a bad mistake, you take every measure you can to avoid making it again? This limits your opportunity, especially with your money.
  • Endowment Bias: This is when you overinflate the value of your investments, similar to how homeowners often think their home is worth more than it actually is.
  • Herd Mentality Bias: So many investors are guilty of going with the herd on investments, whether it’s with friends, coworkers, or the media.
  • Anchor Bias: This can happen when the price of a stock shoots up or down, and an investor makes a decision to buy based on what the previous and current price is. They’re not valuing the price correctly because they’re anchoring to the higher price.
  • Illusion of Attention Bias: This is prone to happening when you invest in individual stocks, and focus all your attention on how they’re performing. This distracts you from the total performance of your portfolio.

In short, don’t fall prey to your emotions. They won’t guide you to road that leads to financial independence. Instead, base your investment decisions on sound principles, thoroughly research your options, make use of reputable resources, consult with your financial advisor, and don’t forget to enjoy life along the way.

Money is a tool to accomplish what you want in life, but don’t let the market influence your emotions to the point of being miserable.

Why (and How) You Need to Plan for the Cost of College

College

The Money-Guy show is back this week and Brian and Bo are talking about the importance of figuring out how to pay for college.

In light of a recent New York Times Op-Ed piece written by Lee Siegel, Why I Defaulted On My Student Loans, Brian and Bo wanted to offer more helpful and proactive advice to parents and students out there contemplating the cost of college.

Fidelity published a great article around the same time, titled How Much College Can You Afford? The Money-Guys take a look at both sides of the coin in this episode and suggest how you can plan for the cost of college (so that you don’t need to worry about defaulting on loans).

How Planning Ahead Can Prevent Dire Situations

After reviewing Lee Siegel’s story, Brian and Bo discuss how proper planning, including calculating how much student loan debt you could reasonably afford to take on, can help avoid those kinds of financial situations.

Another article, Student Loans and Defaults: The Facts, was published after Siegel’s piece ran and took a deeper look at the details. This piece reveals that Siegel graduated from Columbia University with a bachelor’s degree and two master’s degrees. Obviously, that must have cost a pretty penny! Considering Siegel wanted to be a writer, were three degrees even necessary?

The typical writer’s salary isn’t going to cut it when paying back loans for three degrees from an Ivy League school. Siegel attempted to blame the broken student loan system for his predicament, but there’s an element of personal responsibility to consider here, too.

Don’t let this happen to you or your kids. There’s no reason to consider defaulting on your student loans and ruining your credit score because you didn’t plan ahead properly.

How to Plan Ahead for College Expenses

How can you plan ahead for college, especially if you’re a parent whose kids aren’t sure what they want to do or where they want to go? Fidelity’s article has some great insights.

First, you need to consider salary projections. If your child knows what they want to major in, they can use this handy calculator from finaid.org to figure out how much debt they can truly afford. The average starting salary for a particular field is taken into consideration, and this provides you with a reasonable estimate of how much student loan debt your child will be able to handle based on that salary. Student loan debt shouldn’t exceed more than 10% – 15% of your income.

Second, create a realistic budget. Figure all the possible costs associated with college — not just tuition. Include post-graduate education if it’s required for the field your child wants to study.

Third, encourage your child to help pay for their education. According to Fidelity’s article, more and more parents are choosing this route as they plan for college alongside their retirement. (After all, there are no loans for retirement!) Students can work part-time during college, live at home and commute, go to a public university (instead of a private college), or set aside savings.

There’s no excuse for not planning ahead. You don’t have to end up in a situation where you think your only option is to default on your loans. Defaulting has serious consequences that Siegel downplayed in his article.

When you sign your promissory note, you’re making a promise to repay your loans. Be responsible about your choices and fulfill that promise.

5 Investment Mistakes Couples Make

Investment Mistakes Couples Make

Have you talked with your spouse about your investment strategy, or what the purpose is for your investments? Investing can be tricky enough alone, but it’s extremely important to include your other half in investment decisions so that you’re on the same page about how your money is being put to work.

If you haven’t yet discussed investing with your partner, you should read on to be aware of the common investment mistakes couples make so that you can avoid them.

Mistake #1: Only One Spouse Has Contact with a Financial Advisor

It doesn’t matter if one of you is more comfortable with the idea of investing. Both of you should be attending meetings and calls with your financial advisor because you’re in this together. You both have an equal stake in how your portfolio performs.

In the event that something happens to the spouse handling investments, the other will be lost when it comes to picking things back up. Avoid this burden by working as a team.

Mistake #2: Not Being Clear on Common Goals

You should be investing with a goal in mind — whether you’re aiming for early retirement, funding your children’s college expenses, or saving up for a down payment on a house in five years.

Are you and your spouse in agreement on your investment goals? If you haven’t talked about investing beyond “it’s the right thing to do”, then you should. Otherwise, you might face an issue down the road where one spouse wants to withdraw money early from a retirement account for an expense that was never discussed.

Mistake #3: Investing Without Being Informed

Just because your investments might be managed by someone else doesn’t mean you should blindly follow their advice. You should absolutely know what you’re investing in and be a part of the decision process.

Never be afraid to ask your advisor questions. They should be able to answer them honestly, and they should want you to understand the reasons behind their investment decisions.

Mistake #4: Not Taking Advantage of Employer Matching Contributions

Do you and your spouse have a 401(k) retirement plan offered through your employer? Are you contributing enough to receive the amount your employer will match?

If you don’t know the answers or aren’t sure, you need to look into this. You could be leaving free money on the table. You should be able to ask your HR department about the details of your retirement plan.

If you’re not sure what matching contributions are, here’s an example of how they work: If your gross annual salary is $75,000 and your employer matches contributions up to 6%, then that means you have to contribute 6% ($4,500) of your salary for them to match that contribution.

If you only contribute $3,000, then you’re missing out on $1,500 from your employer. Likewise, anything above $4,500 won’t be matched, but you’ll still be funding your retirement.

Mistake #5: Being Unaware of How Your Advisor is Paid

One of the biggest mistakes you can make is hiring an advisor without knowing how they get paid. Are they fee only, do they get paid a commission, or a hybrid of both?

This is important because you want to ensure there’s no conflict of interest when your advisor recommends certain products to you. If they make a commission off of sales, then they might not be looking out for your best interests.

You should also check to see if your advisor is a fiduciary. If they are, then there’s no doubt they’ll be acting in your best interests, as financial fiduciaries are required to do so upon taking an oath.

To avoid these common investment mistakes couples make, remember that investing requires teamwork. Neither of you should be working alone when it comes to financial matters.

If you don’t have confidence in your knowledge of investing, you can always learn from the many resources available to you online. Building wealth through investing will ensure a successful financial future, and it’s not a matter to take a backseat on.

Fiduciaries: What They Are and Why They Matter

Fiduciaries

Have you heard the term “fiduciary” before? It’s may not be a term you use every day, but it’s extremely important to understand when it comes to your financial situation.

If you have a financial advisor managing your assets, you’ll want them acting as your fiduciary. Here’s why.

What Is a Fiduciary?

Fiduciary means “involving trust,” and someone acting as a fiduciary has undertaken the responsibility to provide the highest standard of service for their clients. That means fiduciaries eliminate conflicts of interests and put the needs of their clients above everything else.

Trained, certified, and educated professionals act as fiduciaries for average individuals in a number of fields, including finance. They have highly specialized knowledge that isn’t common across a general population, and as such they can make the right, informed decision about complicated issues where other people may not have the knowledge to do so successfully.

That’s why it’s important your financial advisor acts as your fiduciary. A professional who takes a fiduciary oath swears to act in your best interests at all times. Having a financial advisor act as your fiduciary ensures that your needs are put first.

Why It’s Important that Professionals Work as Fiduciaries

If you’re worried about a financial advisor being motivated to recommend certain products because they make a commission on them, then having a fiduciary can erase that worry. Since they are committed to your financial well-being, they will only recommend products they truly believe will work in your favor.

This also means they won’t try to push you to buy certain financial products that you don’t need or don’t make sense for your situation.

Essentially, your fiduciary will be biased toward helping you. If you ask for their opinion on two different products, they should be able to explain the benefits and drawbacks of each, and then explain their reasoning for picking one over the other in your particular case.

Having this trust also makes it easier to form a relationship with your advisor. If you ever need to consult with them on your financial goals, you can do so without the worry that they’re only out for themselves.

Their number-one goal should always be to build and preserve your wealth to the best of their ability.

Finding a Fiduciary You Can Trust

As you want your relationship with your fiduciary to be based off of trust and respect, it’s important that you find an advisor willing to answer all of your questions. They should be transparent about their practices and the products that they sell (if any).

Do your due diligence in researching advisors, and be aware of the different ways advisors get paid. A fee-only structure further ensures that advisors only get paid what you pay them — they don’t earn commissions off what their clients do.

However, if an advisor is fee-based, then they can charge a flat fee or get paid via commission. Ask your advisor about their fee structure and make sure it’s going to benefit you. There shouldn’t be any hidden fees.

And don’t be afraid to ask an advisor, “Are you a fiduciary?” or “Would you be willing to sign a fiduciary oath before working with me?” If they refuse to act as your fiduciary, it may be in your best interest to look for a different financial professional to have on your side.

Fiduciaries take their oaths extremely seriously and won’t jeopardize your finances for their own gain. Being able to trust your advisor with your assets will go a long way toward giving you peace of mind when it comes to your portfolio.