4 Common Biases that Affect Financial Decisions

Biases (our tendencies or inclinations) affect the judgments and decisions we make about everything—the foods we eat, the clothes we wear, or where we might decide to live. Biases can be emotional (how we feel about something) or cognitive (how we think about something). However, when it comes to money, some of our biases can potentially lead to poor decisions.

Ahead, we'll explore four common biases that can creep up when dealing with equity compensation and ways to guard against them.

Behavioral bias: It's natural to be swayed by emotions, especially during volatile times when the market moves in undesirable and unpredictable ways. But making a reactionary decision based on emotion can be a costly mistake. 

Solution: Before taking any action, add a time buffer to cool off nerves. If you're more task-driven, map out and review your short-term (in the next few years) goals. These goals will be the most impacted by any downward swing, so make sure what you'll need is in cash or cash equivalents. For everything else, your portfolio allocation should be based on your risk tolerance and timing with your long-term goals. If you feel your portfolio is not aligned with your long-term goals, consider talking with a financial advisor about your situation before deciding. If you don't already have a financial plan, this can be a good time to create one.

Behavioral bias: In some instances, having a strong attachment to your company can lead to unrealistic or inflated expectations for your company's stock performance. You might be overly confident in your company's future performance and may not see potential vulnerabilities that could impact your company's performance.

Solution: It's important to assess your company's stock performance the same way you would evaluate any other company. While you may be confident in your company's future potential due to a project you are involved in, you should also consider potential vulnerabilities that can put your company's stock at risk.

It's important to remember that a company's stock can be subject to unforeseen forces that a company cannot control. Disruptive new technology, changes in laws or regulations, changing consumer tastes, financial recession or an international conflict can lead to volatility with your company's stock. Keep a grounded perspective when thinking about what you expect from your company's stock and its performance which can help you make sound investing decisions.

Behavioral bias: You may feel you face a dilemma: employee loyalty to hold company stock versus sound investment strategies like diversification which can help protect you from being overly concentrated in one stock. Either way you go, you might feel a sense of regret for not taking the other path. You might feel like you're being disloyal to your employer or regret that you might miss out on a potentially big run in the stock price.

Solution: It's important to remember your company offered you stock as a tool to help you reach your financial goals. Diversification is one tool you can use for growth while reducing concentration risk in one particular stock. By periodically examining your portfolio holdings and staying true to a diversified investment strategy, you can make informed decisions when it comes to your equity compensation and diversification.

Behavioral bias: Anchoring happens when investors focus too much on a single piece of information they received early on, such as a company's historical stock price. If you believe your company's stock price will return to a previous high, it can be tempting to cling to the stock—even if better investment opportunities exist.

Solution: Don't let your mind get stuck on one piece of information regarding your company stock. Look at it from a holistic perspective, making sure you clearly understand the historical and potential future performance of your position, how the stock fits into your larger portfolio, your risk tolerance, time horizon, and how your stock might help you achieve your financial goals.