Investment decisions should be based on logic and fact. But it’s easy for emotions and biases to affect your decisions, and this can lead to investment mistakes.
Behavioural bias can be useful in some circumstances. It’s a way of making mental shortcuts when you need to make complex decisions. When you consider how many decisions you need to make day-to-day, being able to make quick decisions is important. However, it’s just as important to recognise when biases can be harmful, and investing is one example.
Biases may come from your past experiences, unconscious beliefs, or the way you use information. Being aware of how biases may influence you can help you reduce the risk of making a mistake. Here are five common cognitive biases that could have an impact on your investments.
1. Confirmation bias
When you’re deciding which stocks, shares, or funds to invest in, you’ll seek out information to help you make a decision. However, in many cases, you will already have a preconceived idea about whether an investment opportunity is “good” or “bad”.
Confirmation bias refers to the tendency to place a great emphasis on information that supports your existing beliefs. With so much information on your fingertips online, it’s often easy to find something that fits in with this. While placing importance on the source that supports your views, you may also disregard information that doesn’t fit your existing ideas. It can mean you end up making investment decisions based on a small sample of information without fully assessing how reliable or relevant it is. Being critical of information is crucial.
2. Loss aversion
When you think of potential investment mistakes, it’s likely that taking too much risk is what comes to mind first. Yet, taking too little risk can be just as damaging.
Previous research suggests that people are more sensitives to losses than wins. So, you’ll feel more pain from a loss than you’d feel joy from a win. In investment scenarios, it can mean you avoid taking risks even when evidence suggests it’s worth it. As a general rule of thumb, the more investment risk you take, the better the potential returns, so loss aversion can mean you miss out.
However, it’s important to take a balanced view of risk. Investment values fluctuate and can fall as well as rise. You need to consider what your risk profile is when investing. It can help you avoid loss aversion while still choosing investments that are appropriate for you.
3. Anchoring bias
How do you decide what a piece of information is worth? Anchoring bias refers to the phenomenon of placing too much emphasis on a single piece of information and anchoring your views to this.
Let’s say you purchased a share and evidence suggests it’s time to sell. Anchoring bias can mean you hold onto the share for longer because you’ve anchored on the higher price you bought it at. This anchoring can give you the view that the share is more valuable than it actually is. This is despite the share price you purchased it at having no impact on the present.
As with confirmation bias, being critical of the information available is important.
4. Hindsight bias
It’s natural to look back at investment decisions and consider what you could have done differently. However, hindsight bias means you attribute different levels of control to decisions depending on their outcome.
It’s a tendency to see beneficial past events as predictable. So, if you made an investment decision that’s performed well, you’d put it down to you foreseeing that the company would perform well. In contrast, you consider bad events as unpredictable, so if an investment performs badly, it’s because it was out of your control. Hindsight bias can make it difficult to objectively look at past investment decisions.
5. Bandwagon effect
Investment decisions should reflect your circumstances and goals, but the bandwagon effect means you make decisions because it appears many people are doing the same thing.
For example, after reading a news article about how everyone is investing in Silicon Valley stocks, would you be tempted to invest in opportunities within this sector? It could be right for you, but if you haven’t reviewed your current portfolio, risk profile, or the investment themselves you could be making a mistake. Speculative bubbles are often the result of the bandwagon effect.
Need help making investment decisions?
Working with a financial planner can help you reduce the impact that bias has on your investments and other financial areas. Being able to discuss your investments and why you’re making certain decisions can be all you need to highlight where bias is occurring. We can also help you understand which investment decisions make sense for you with your goals and situation in mind. Please contact us to talk about your investment portfolio.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Richard Fyfe is a Chartered Financial Planner and a Director of Fyfe Financial.