In times of uncertainty or stress, it can be difficult to make the right investment decisions because we often let emotion or intuition guide us. We are less likely to spend time carefully sifting through all the pros and cons. This default behavior can be an obstacle when trying to achieve our long-term financial goals.
Our emotions and intuition are coloured by behavioural biases that are inherent human trait. These biases are hard wired into our brain as ancient survival techniques adapted by our ancestors when facing danger. The result is our ability to act fast in the face of danger, but when that danger is falling markets the resulting decision can be damaging to the investment portfolio.
The field of study into how investors make decisions in relation to money is known as behavioural economics. Research in this field has identified many biases that influence the financial choices people make. Below we list some of the more common ones.
Overconfidence
Overconfidence bias is the tendency for people to overestimate their abilities and talent. They believe that they are better than they actually are. In investing, they may think they understand the markets better than they do and that, if things don’t work out as expected, they will be able to escape bad outcomes. This bias can lead people to take on too much risk, hold overly concentrated portfolios or trade too frequently. It may also make people ignore advice from others, including financial advisors.
Loss aversion
Loss aversion drives people to prioritize avoiding losses over earning gains. Behavioral scientists have found that the pain of a loss is felt more strongly than the pleasure of an equivalent gain. Loss aversion can lead to portfolios that are too conservative and may not generate the growth needed to achieve investment goals.
Representativeness
The representativeness bias is classifying new information based on past experiences. For example, people focus on recent investment returns as an indicator of future performance. People tend to make decisions based on a short-term trend or limited amount of information without considering whether the success is repeatable or even if what has happened recently is indicative of what happens next.
Anchoring
This is a psychological tendency to make irrational, illogical investment decisions based on an initial reference point driven by emotions. The anchoring bias can lead to decisions based on an impulsive first impression. An example of anchoring is determining how cheap a mutual fund is based on how far the current price is from it’s all time high. This could be misleading because the mutual fund may be considered cheap when in fact it’s still overvalued.
Recognizing these biases that influence investment decisions is an important first step but even when you know what they are, it can still be hard to sidestep them. My role as a financial advisor is to help promote rational, thoughtful, bias-resistant decisions that protect clients’ ability to reach their long-term financial objectives.
Mani (24-June-2021)
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