5 Ways to Avoid Present Bias in Investment Decisions
What Is Present Bias?
In behavioral economics, present bias is a form of time-inconsistent preference whereby individuals overvalue more immediate rewards or benefits at the expense of future rewards or benefits.
Present bias can lead people to make irrational decisions that favor short-term gains, often at the expense of long-term well-being. For example, a person might choose to spend money on a vacation instead of saving for retirement, or opt for a high-calorie dessert instead of a healthier diet.
In investing, present bias can take the form of hyperbolic discounting, where people discount the value of future rewards far more steeply as they get closer to the present. In other words, people tend to place a much higher subjective value on rewards received in the very near term than those received further in the future, even if the latter are objectively more valuable. This can lead to a misaligned preference for short-term opportunities with immediate payoffs over long-term investments with greater overall expected returns.
Key Takeaways
- Present bias occurs when people place far more weight on near-term benefits at the expense of longer-term ones.
- This can negatively impact investing decisions by favoring short-term gains over long-term growth.
- Investors may experience present bias as hyperbolic discounting.
- Overcoming present bias involves adopting strategies that prioritize long-term investing success.
- Identifying and understanding other cognitive biases can also help improve investing decisions.
How Present Bias Impacts Investing Decisions
Present bias can distort individuals’ perceptions and plans about the future, leading them to rush into short-term consumption because the immediate rewards seem promising. This can result in impulsive decisions that may not align with one’s long-term financial goals. For instance, an investor might be drawn to the potential high returns of a speculative investment without considering the risks involved, and at the expense of investing in a more diversified account for the long run.
For example, an investor might choose a high-dividend-yield stock over a growth stock with no dividends but higher potential for capital appreciation in the future. Such a preference for immediate dividend payments can lead to missed opportunities for long-term wealth accumulation.
Risk-averse investors may also exhibit present bias due to loss aversion. Loss aversion is when we prioritize avoiding losses over achieving gains. As delaying a reward may imply the possibility of not ever receiving the reward, risk-averse investors tend to act present biased.
Moreover, loss aversion implies that people will avoid locking in a loss and actually seek more risk in hopes of making back their money. Present bias may also be at play by putting off the sure thing of locking in a loss. Research also shows that investors tend to be more conservative and risk-averse when they have shorter time horizons, which could be driven by loss aversion and the fear of not receiving future rewards.
5 Tips to Overcome Present Bias
- Set SMART goals: Establish specific, measurable, attainable, relevant, and time-bound (SMART) investment goals to help you maintain focus on long-term objectives, reducing the influence of present bias and the impulse to act in the short term.
- Adopt a long-term investment strategy: Develop and stick to to a long-term investment strategy, such as dollar-cost averaging or dividend reinvestment, that encourages consistent, disciplined investing over time.
- Diversify your investment portfolio: Diversification can help reduce the impact of present bias by spreading your investments across various asset classes and investment vehicles, thereby mitigating the risks associated with short-term fluctuations in the market.
- Implement a cooling-off period: Before making any new investment decision, give yourself a cooling-off period to reevaluate the decision and consider its long-term implications. This can help prevent impulsive decisions driven by present bias.
- Seek expert advice: Consulting with a financial advisor or broker can provide an objective perspective on your investment decisions and help you identify and overcome present bias.
What causes present bias?
Present bias is thought to be a cognitive error caused by our innate preference for immediate gratification and our tendency to put off thinking about our future selves. Cultural forces that promote such preferences for the short term at the expense of the long term may also play a role.
Is procrastination a form of present bias?
Procrastination is the purposeful act of delaying or postponing important tasks or decisions, often despite knowing that there may be negative consequences for the delay. Procrastinators may put off tasks because they overvalue the immediate utility of engaging in more enjoyable activities or avoiding discomfort in the present moment. Procrastination could be considered a special type of present bias, since it involves prioritizing short-term comfort over the long-term benefits of completing a task or making a decision.
How does present bias affect consumers?
Present bias can lead consumers to make impulsive purchases, overspend, and take on excessive debt. These behaviors can result in a preference for spending over savings, which can result in long-term financial instability, such as not having enough retirement savings later in life.
What are some other biases that affect investing decisions?
The Bottom Line
Present bias is a form of inconsistent temporal choice that occurs when people more heavily weight short-term benefits at the expense of long-term benefits. This can have a significant impact on one’s financial well-being, as impulsive spending or speculation can preempt long-term savings and strategic investing decisions.
Present bias can take the form of hyperbolic discounting, which often leads to short-term thinking and suboptimal outcomes. By recognizing and addressing present bias, individuals can make more informed decisions that prioritize long-term financial success. Implementing strategies such as setting clear investment goals, adopting a long-term investment strategy, diversifying, and seeking professional advice can help mitigate the effects of present bias.
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