Behavioural finance tells us that when it comes to decision-making we might not be as rational, self-controlled, and impervious to investment bias as we might think.
You probably have some subconscious biases yourself, and they might be having a detrimental impact on your potential investment returns.
By acknowledging that these behavioural biases exist, and then working to understand them, you could improve your chances of seeing healthy investment returns.
What is investment bias?
Maybe you’re a cautious investor, worried about making wrong decisions, and therefore prone to getting too caught up in the short-term?
You might be more of a risk-taker, but might your overconfidence be exposing you to unnecessarily high risk?
You may have a kind of herd mentality, following investments made by others without considering how they fit into your own long-term plans.
Biases can affect the way you approach investment choices, as well as the decisions you ultimately make. They can be cognitive or emotional, and both could be having a detrimental impact on your investment returns.
Cognitive vs Emotional bias
Cognitive biases involve making a decision based on pre-conceived ideas. They are a kind of rule of thumb. As with a rule of thumb, they might not be accurate 100% of the time.
Emotional biases, on the other hand, are based on personal feelings at the time a decision is made. They could be spontaneous, knee-jerk reactions, but they might also be based on deep-rooted psychology.
Neither bias is necessarily always wrong, but it pays to be aware of them and to think about the ones that might be affecting your decisions.
Types of cognitive bias
The newspaper you buy is probably the one most aligned with your views. You might be doing a similar thing with your investments.
A natural human tendency is to pay particular attention to information that supports an idea we already hold. This often means ignoring opposing information or facts – however logical or compelling – and preventing us from seeing the bigger picture.
If you hold a strong belief about a specific investment opportunity, you might find yourself placing more weight on opinions that match your own. Searching for information contrary to your beliefs and approaching that information objectively, might allow you to question your firmly held belief and maybe think again.
At the very least you’ll gain a well-rounded view and give yourself the best chance of making a good decision.
Trend chasing bias is a herd-mentality, or bandwagon, effect.
As we mentioned earlier, it might lead to you making a certain investment because it’s the one everyone else is making.
You could also find yourself holding on to an investment because it gave favourable returns in the past, even if its present performance is poor.
American investor, Warren Buffett’s advice for avoiding this trend-chasing bias was, “Be greedy when others are fearful and fearful when others are greedy”.
Following the crowd won’t always be wrong, but you should ensure your decision is based on thorough research and that the investment fits your own risk profile, values, and long-term financial plans.
You might show a subconscious bias towards ‘big name’ investments or familiar companies, even when their stock is performing poorly.
By concentrating only on the familiar, you might miss out on other, less visible opportunities with potentially higher returns.
You might also find that you narrow your portfolio, limiting the positive effects of diversification.
Types of emotional bias
If you suffer a heavy investment loss, you may react emotionally. You might even take the loss personally. You’ll probably react in a similarly emotional way if you make a large gain but it’s likely that you’ll move on more quickly and not feel the same attachment to the decision. You might even tell yourself the gain was inevitable. This is loss-aversion bias.
We take losses to heart and are more likely to dwell on them, whereas gains are easily forgotten. Because of this, we subconsciously place greater emphasis on avoiding losses, than on achieving gains. This can lead to bad or even irrational decisions.
Maybe you have an investment that has made a loss but you can’t bear to sell? This could be loss-aversion bias.
Selling would mean admitting the loss – and potentially the original bad decision – while keeping hold of the investment you keep hold of the hope that its performance might improve in the future, maybe even breaking even.
Self-attribution bias is a human trait linked to self-confidence.
You might have this bias if you find yourself attributing your successful investments to your own skill but any losses to outside factors beyond your control.
You might believe your expertise in a certain sector, or knowledge of a certain asset gives you an advantage. Try to ensure that you’re making decisions based on the available evidence, unclouded by bias.
Endowment bias might see you place a higher value on assets you already own than on those you do not. This sense of ownership could cloud your judgement meaning you hold on to an investment when you shouldn’t, or forgo other opportunities.
This can be particularly common with inherited investments. Take a step back, look at the investment objectively and then make a decision.
Get in touch
As finance professionals, we understand the subconscious biases that exist and the pitfalls that investors can succumb to.
Please get in touch if you’d like to discuss any aspect of your current investment portfolio.
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