To be a successful investor over the long term, we believe it is fundamental to recognise, and hopefully overcome, common human behavioural biases that often lead to poor decisions and investment mistakes.
We have highlighted 5 typical behavioural biases that investors suffer from.
1. Confirmation bias
Confirmation bias is the inherent human propensity to seek out or conversely neglect information that strengthens their existing opinion. As such, confirmation bias is highly correlated to investors being overconfident because their confidence is derived from subjective data as opposed to a neutral assessment. Consequently, this leaves investors highly exposed to unexpected shifts in the marketplace primarily due to lack of diversification.
How to avoid Confirmation bias
To minimise the risk of confirmation bias it is important that you challenge the ‘status quo’ and gather information that forces you to evaluate your assumption. In doing so, you are able to weigh up all the advantages and disadvantages of the investment to formulate a unbiased decision with a broad selection of data (that is not subjective to one side). Overconfidence can also be mitigated by greater diversification of your investment portfolio, to limit exposure.
2. Bandwagon bias
The Bandwagon bias or herd mentality is simply the notion of gaining comfort in numbers by way of doing something because many others are doing or saying the same thing. By taking part in this culture you begin to disregard facts and start to follow opinions or trends that are not of your own judgment. In doing so you neglect to assess whether the investment is right for you but rather invest because everyone else is. Herd mentality also happens to be the cause of speculative bubbles that are synonymous with massive declines once the bubble is inevitably popped.
How to avoid Confirmation bias
To avoid this risk, it is imperative that as investors you must be able to analyse and think independently. By doing so you can identify when a financial phenomenon has factual evidence to back it up or whether it’s just herd mentality inflating its actual merit. Consulting with your financial advisor will also help clear the air when it comes to these types of investments.
3. Loss Aversion bias
Loss Aversion bias details the notion that investors inherently prefer to avoid losses rather than obtain gains. This bias stems from the endowment effect which suggests that we as humans place a greater value on goods that we own as opposed to identical goods that we don’t. The issue with this is that investors begin to make poor and irrational investment decisions, whereby they refuse to sell loss-making investments in the hope of making their money back. In doing so, investors pass up on future investments that could be seen as far more profitable opportunities.
How to avoid Loss Aversion bias
Aversion bias is understandably a difficult behaviour to shake off. The key to this is viewing all existing investments as sunk costs and a decision to retain or sell an existing investment must be measured against its opportunity cost (new investment). By doing so, the investor can view the current investment and the alternative in a neutral perspective to ultimately choose the right investment.
4. Restraint bias
Restraint bias is the perception that humans overestimate their ability to show restraint in the face of temptation. In terms of investing, this relates to how to properly size an investment when one believes they have identified a ‘sure winner’. It is very common for investors to overindulge in their ‘best investments’ and fail to view other alternatives. In doing so they risk overexposure within their portfolio resulting in greater losses if unexpected changes in the market occur.
How to avoid Restraint bias
It is crucial to set limits on exposure to certain markets and make sure your portfolio covers an abundance of domestic and foreign investments. This limits your exposure to unexpected changes in the market and insures your ‘sure winner’ does not compromise your portfolio. As always it is highly recommended to consult with your financial advisor regarding exposure weightings and diversification issues.
5. Anchoring bias
Anchoring bias is the tendency of investors to rely heavily on past references or one piece of information when making a decision. A textbook example of an anchor is replying on recent share prices. Unfortunately, where a share price has been in the past presents no information as to whether or not a stock is cheap or expensive. Anchor bias may also hinder future investments if the investor is unwilling to sell their current stock because of past performance. Additionally, this may also increase the risk of investors making bad investments based on past performance rather than current data.
How to avoid Anchoring bias
To avoid anchoring bias, investors shouldn’t hold any past references as an accurate indicator of future performance. Investors should assess the validity of an investment on multiple fronts and from both a quantitative and qualitative standpoint. By doing this, the investor will be able to draw a more comprehensive conclusion that doesn’t rely on anchors.