Sorry, but your biggest investing problem could be you
Every day we make numerous judgements and decisions. As the human brain has evolved it’s developed little short-cuts, or ‘heuristics’. These mental pathways circumvent multi-stage decisions and allow us to make judgements quickly and efficiently. While heuristics are helpful and allow us to function without stopping to think about our next action, they can – and do – lead to cognitive biases. These biases sometimes trip us up leading to bad judgements and poor decisions.
Unfortunately – and consequentially – such biases exist in the full spectrum of our decision-making, including those in the realm of investing.
A vital ingredient to successful investing over the longer term is knowing yourself – and specifically knowing the mental traps you may fall into when making investment decisions. Here are a few of the more typical behavioural biases of investment decision-makers.
Anchoring bias is the tendency to rely on a particular event or piece of information. Many people base their investment decisions on the current price of an asset relative to its history. Another anchor is the purchase price of an asset. While a gain or loss represents the difference between the current price and the purchase price, is this actually helpful when deciding to buy, hold or sell?
People also anchor to events, with a good example being the Global Financial Crisis. Many investors, scarred by their loss of capital through the GFC, now anchor to the event (and the associated financial loss or psychological pain) when making investment decisions.
Investors should attempt to determine an asset’s current and potential future worth in isolation from other values (or events).
Humans are hard-wired to herd. So it’s not surprising that this is common in investment circles. With this bias there’s an element of FOMO (fear of missing out) when there’s a bull-rush to a type of investment (think tech stocks in 1999); there’s the psychological pain of going against the crowd; and then there’s the fear of humiliation or embarrassment (aside from the financial consideration) of just being proven wrong.
Recognising the lure of running with the pack requires an ability to think independently. Be self-aware about the social and emotional pull of the herd.
Confirmation bias is the tendency of people to pay close attention to information that confirms their belief and ignore information that contradicts it. This can lead to overconfidence and the risk of being blindsided.
It feels good to hear our opinions reflected back to us. There’s nothing particularly wrong with this, but such bias can validate and reinforce a view which may be flawed. Instead, we should be looking for disconfirming information to test against an initial view. A discipline of stress-testing and deconstructing ideas runs consistent in many of the world’s most successful investors.
People tend to overestimate their skills, abilities, and predictions for success. Careful risk management is critical to successful investing and overconfidence tends to make us less cautious in our investment decisions. Many of these mistakes stem from an illusion of knowledge and/or an illusion of control. Overconfident investors often put down their wins to talent and losses to plain bad luck. Guarding against overconfidence involves acute self-awareness and the ability to isolate the role of skill versus timing, or luck.
Unfortunately – and consequentially – such biases exist in the full spectrum
of our decision-making, including those in the realm of investing.
Loss aversion is a tendency to dislike losing money a lot more than enjoying making money. The GFC is a period in many investors’ lives which created an enduring fear of substantial loss. Scarred by losses from such periods, investors can be at risk of creating portfolios too conservatively invested with a primary goal of fortifying against loss, rather than looking at their time horizon and structuring a portfolio to suit.
Investors need to remember that to generate a certain level of returns they need to take a certain level of risk, and periods of negative returns are to be expected when taking on risk. The idea is to not take excessive risks in seeking to achieve a return goal.
What are your biases?
What biases might you be most prone to? Can you ascribe one or more biases to an investment mistake?
Common to overcoming a lot of these biases is the ability to think independently. And if you can’t do this, or don’t have the time and energy, then consider employing a professional investment manager to do it for you. The best money managers are acutely aware of their biases and actively guard against them by slowing down and testing decision drivers before transacting.