5 common behavioural biases that can affect your investment decisions

Published in June 2020

Article Summary

Behavioural finance is a fascinating field that studies how we human beings often make irrational financial decisions. By understanding and identifying the biases that can undermine your investment decision-making, you may be able to avoid common pitfalls and achieve better outcomes with your portfolio.

Every day, you make decisions that are laced with a healthy dose of bias without even realising it. You may decide to buy the new iPhone because everyone else is getting it, for example. Or you may refuse to scrap your car even though it has proven to be a lemon and continue to pour money into fixing it.

“The investor‘s chief problem – and even his worst enemy – is likely to be himself.”

Here are five common behavioral biases you should familiarise yourself with.

5 common behavioural biases

1 Herd mentality
2 Loss aversion
3 Recency effect
4 Confirmation bias
5 Overconfidence

1 Herd mentality

Remember when your parents reprimanded you by asking, “If your friends jumped off a cliff, would you follow them?”

They are referring to a herd mentality – where people react in the same way as others around them, rather than to make a rational decision for themselves.

This is not to say that herd mentality is a bad thing all the time. As an instinctive reaction, running in the same direction as everyone else has helped our ancestors in self-preservation, allowing them to escape dangers that they didn‘t see coming.

However, when it comes to investing, it can have the opposite effect.

When you see other investors, friends or family rushing to invest in a hot stock or sector, you may be influenced to follow them to avoid missing out. Rather than to assess an investment on your own, you may end up joining the “herd” and investing blindly.

The herd mentality is responsible for many of the stock market bubbles – and crashes -- in our time. For instance, during the dot-com boom in the late 1990‘s, many investors rushed to invest in tech companies that did not have sound business plans or track records of profitability. We all know what happened next: the bubble eventually burst, and the Nasdaq Composite Index, which had risen five-fold from 1995 to 2000, lost almost 80% of its value by the end of 2002. You can rely on one of Warren Buffett‘s most famous quotes to help you go against the herd:

“Be fearful when others are greedy, and be greedy when others are fearful.”

2 Loss aversion

Loss aversion refers to people‘s tendency to prefer avoiding losses more than acquiring gains of an equivalent value.

You may encounter loss aversion after making an investment and seeing prices plunge subsequently. You may continue to hold on to losing positions because you do not want to realise a loss, in the hopes that prices will eventually rebound. However, you may end up making further losses, if the fundamentals of your investment have turned sour.

On the other hand, if the price increases, you may be too eager to sell the stock, even though you believe the company has the potential to perform well going forward, because you fear losing out on realising your profits.

What this leads to is the opposite of what most investors would want – cutting your losses short and letting your winners run.

3 Recency effect

People tend to pass judgement on things based on two key milestones – their first impression and last impression.

The recency effect refers to the latter, where there is a tendency to put more weight on things that happened most recently compared to those that happened a long time ago.

In the investing world, this means investors tend to have short memories. During a bull run, people tend to forget the last bear market. Similarly, during a downturn, people can become overly pessimistic which depresses the market more.

To combat this, investors need to understand that economic cycles are a reality. During an upturn, investors need to understand that markets cannot rise forever, and during downturns, investors should avoid panicking.

4 Confirmation bias

Confirmation bias happens when you look for information that favours your own opinions and downplay information that challenges it. When you believe in an opinion, you tend to read articles that agree with your point of view. You also end up speaking to more people with the same beliefs and perhaps discount those with differing views.

For instance, if you are already bullish about a particular stock, you may find yourself constantly hearing good news about the company which reaffirms your belief that you should invest in the stock as soon as possible.

As an investor, you may unknowingly miss out on or neglect information that is important to making an objective decision if you are dismissive about information that goes against what you believe. By being open-minded about information, especially those that contradict your opinions, you can make better and more independent investment decisions.

“What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”

5 Overconfidence

An overconfidence bias occurs when you think your knowledge or ability is greater than it is. Many scientific studies measuring how people rate their own driving skills have found that individuals tend to rate themselves as better drivers than others on average. Of course, it is impossible for everybody to be better than average.

This way of thinking is not only prevalent among drivers but also holds true about how people rate their abilities as professionals, leaders, athletes and investors. While confidence can be a valuable trait, it can also lead to biased and sub-par investment decisions.

As an investor, you may (mistakenly) believe that you are a better-than-average stock picker or that you have an edge when it comes to investing in companies in a particular sector because you work in the field. This could lead you to make an investment decision without the proper research or based on unfounded hunches.

Becoming a better investor

Even if you believe you are an objective or open-minded person, you have to accept it is very likely you also have biases that are shaping your opinions.

While it can be difficult to fight these tendencies, knowing they exist and understanding how they work can help you to overcome them, or at least be aware of them. And the next time you find yourself falling into one of these behavioural traps, make a conscious effort to fight them – this could make a difference to your investment returns.

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