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How our behavioural biases affect investment behaviour


Research in psychology has documented a range of decision-making behaviours called biases. These biases can affect all types of decision-making, but have particular implications in relation to money and investing.

Behavioural finance believes that investment decisions are influenced by two primary personal preferences called cognitive errors and emotional bias. Cognitive errors describe how people think, and result from the inability to analyse information correctly. Emotional biases are the result of factual reasoning over-ruled by feelings.

Emotional biases tend to sit deep within our psyche and may serve us well in certain circumstances. However, in investment they may lead us to unhelpful or even hurtful decisions. Behavioural finance recognises four key ways in which emotional biases are expressed through our investing actions. These include: overconfidence, self-attribution, loss aversion and inertia. Below we look at some of the key attributes of each, how they might affect our investing decisions, and how we can work to overcome them.  

Overconfidence and over-optimism bias
While confidence and optimism can be valuable, it can also cause an ongoing source of bias in money-related decisions. Confidence suggests a realistic trust in our abilities, while overconfidence implies an overly optimistic assessment of one’s knowledge, skill or level of control over a situation.

Overconfidence has two components: an illusion of knowledge and an illusion of control. For instance, traditional finance theory suggests holding diversified portfolios so that risk is not concentrated in any one area. Misguided conviction can weigh against this advice, with investors ‘sure’ of the good prospects of a given investment, causing them to believe that diversification is unnecessary.

Overconfidence bias can lead us to take on more risk than we perhaps should, because we believe our personal performance is higher than it really is. This can lead us to believe we are better than others, due to a false sense of skill, talent, or self-belief.

How to avoid this bias
Trade less and invest more. By increasing your time frame, mirroring indexes and taking advantage of dividends, you will likely build wealth over time. Resist the urge to believe that your information and intuition is better than others in the market – don’t forget we are now trading against computers who have vastly more information than we do.

Self-attribution or hindsight bias
Overconfidence bias may also be fuelled by another characteristic known as self-attribution bias. This means that individuals when faced with a positive outcome following a decision, will view that outcome as a reflection of their ability and skill. However, when faced with a negative outcome, this is attributed to bad luck or misfortune. This bias gets in the way of the feedback process by blocking out negative feedback.

This is a dangerous limit to our learning because in practice there could be a whole host of reasons why we’ve had an unexpected success or an unexpected failure.

How to avoid this bias
When you experience setbacks, resist the urge to pass the blame, and take ownership instead. Keeping an investment diary, comparing outcomes to the reasoning behind our investment decisions, is also a good way to keep this hindsight bias in check.

Loss aversion and regret avoidance bias
Established financial theory also focuses on the trade-off between risk and return. The theory assumes that investors seek the highest return for the level of risk they are willing to bear. However, behavioural finance suggests investors are more sensitive to loss. For instance, most people require an even (50/50) chance of a gain of $2,500 in a gamble to offset an even chance of a loss of $1,000 before they find it attractive.1

The idea of loss aversion also includes the finding that investors try to avoid locking in a loss. Consider an investment bought for $1,000, which rises quickly to $1,500. We would be tempted to sell it to lock-in the profit. In contrast, if the investment dropped to $500, we would tend to hold it to avoid locking in the loss.

More generally, investors with losing positions show a strong desire to get back to break even – we are all victims of this. This means we show highly risk-averse behaviour when facing a profit (selling and locking in the sure gain) and more risk tolerant or risk seeking behaviour when facing a loss (continuing to hold the investment and hoping its price rises again).2

This is the flip side of overconfidence and causes us to make decisions in a way that allows us to avoid feeling emotional pain in the event of an adverse outcome.

How to avoid this bias
Don’t trade on emotion. Set trading and investing rules that never change. For example, if a stock trade loses 8% of its value, exit the position. If the stock rises above a certain level, set a trailing stop that will lock in gains if the trade loses a certain amount of gains.

Inertia bias
Inertia is the inability to act, often even on things we want or have agreed to do.  The human desire to avoid regret drives this behaviour.

Inertia can act as a barrier to effective financial planning, stopping us from saving and making necessary changes to our portfolios for instance. For example, if an investor is considering making a change to their portfolio, but lacks certainty about the merits of acting, the investor may decide to choose the most convenient path – wait and see. In this pattern of behaviour, so common in many aspects of our daily lives, the tendency to procrastinate dominates our financial decisions.

How to avoid this bias
Your financial adviser is key to recognising when you might be suffering from inertia and can help you implement strategies to reduce the impact of this bias on your portfolio. This might include the automatic rebalancing of portfolios and dollar cost averaging for instance.

Overcoming bias in investing
Many of these traits are human qualities that are not easily turned off. When it comes to money, we all have the tendency to behave irrationally at times - many of us will go to great lengths to rationalise our historical investment decisions, especially failed investment decisions. In extreme cases, this could lead us to continually delaying selling positions that are not generating adequate returns in the believe that one day they will ‘come right’.

For investors who tend to be overconfident, they believe they are better able to perform a certain action or task than they really are. For others, the fear of making a loss can lead to in-action when confronted with the potential for an investment to lose value.

These are not uncommon biases. We are unlikely to find a ‘cure’ for our biases, but if we are aware of our biases and their effect, we can possibly avoid the major pitfalls. Ben Franklin wrote in the 1769 Farmers’ Almanac, “there are three things extremely hard: steel, a diamond, and to know one’s self.” To make sound choices, you must know yourself to know what decisions your personality can withstand when building and implementing an investment policy and process.

Your financial adviser can help you to create a portfolio which reflects both your needs and personality. They will also work with you to determine your attitude to risk, and will consider issues such as investment time horizon and wealth level to establish your risk tolerance.

 

[1] James Montier, Behavioural Finance, 2002.

[2] Daniel Kahneman and Amos Tversky, ‘Prospect Theory: An analysis of decision making under risk’, Econometrica, 1979.



Important information and disclaimer

This article has been prepared by Godfrey Pembroke Limited ABN 23 002 336 254 AFSL 230690. Any advice provided is of a general nature only.  It does not take into account your objectives, financial situation or needs. Please seek personal advice before making a decision about a financial product. Information in this article is current as at 4/02/2020.  While care has been taken in the preparation of this article, no liability is accepted by Godfrey Pembroke Limited or its related entities, agents or employees for any loss arising from reliance on this article. Any opinions expressed constitute our views at the time of issue and are subject to change.  Any tax information provided in this article is intended as a guide only.  It is not intended to be a substitute for specialised tax advice.  We recommend that you consult with a registered tax agent.

 

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