Overcoming the common behaviour biases for the good of your investment
When many talk about picking the “right” investments, they tend to base their decisions on research and attaining a good understanding of the investment.
However, beginners as well as seasoned investors can be affected by emotions or make mistakes while processing information. This is a critical aspect related to a person’s instinct, which guides their decision making towards investing and savings, also known as behaviour biases. While we may not eliminate these biases totally, it is important to understand them to prevent ourselves from making irrational decisions that may have a negative impact on our wealth.
One of our core wealth principles is Discipline. Discipline helps to remove emotions from your investment decisions (during good and bad times) and ensures you maintain focus on your long term investment goals. Discipline involves being aware of behaviour biases that influence our decision making and mitigate these by putting in place an investment plan, outlining how you will invest, and how frequently you will invest, to instill discipline into managing your wealth.
Do any of the following 6 common behaviour biases feel familiar to you?
1. Confirmation bias
One of the most common biases is confirmation bias—seeking affirmation for something you want to believe is true. Your desire to believe something pushes you to favour information that aligns with your beliefs, and discard information that doesn’t.
For example, if a person believes a specific energy company is a sound investment, they will look for information and news that paint the company in a positive light, while overlooking the red flags.
The secret to managing confirmation bias lies in discipline. Be sure to maintain a holistic view on the investment and widen your search for insights and opinions to a range of reliable sources and data. It will not only provide you with sources that challenge your bias, but also give you a more balanced viewpoint on the investment opportunity you are looking into.
2. Information bias
Information bias is especially common with today’s constantly evolving news cycle with regular headlines catching our attention distracting us from our long term investment plan. It results in a person evaluating information which could be unnecessary or irrelevant.
For example, some investors may make investment decisions to buy or sell an investment based on daily price movements, or on news headlines that trigger an emotional response. Focusing on short term market fluctuations and making decisions based on emotion will often lead to unnecessary losses.
Overcoming information bias is important for achieving your long term wealth goals. As market movements are very difficult to predict, especially over shorter time horizons, it is important to stay disciplined, and stay focused on the long term. History has proven that the likelihood of realizing a loss decreases over long term holding periods.
3. Loss aversion
A person with loss aversion is someone with a greater desire to avoid any risk that could bring about a loss, rather than to acquire a similar gain. Simply put, the person would rather not lose $1000 than gain $1000.
Circumvent loss aversion by not staying emotionally attached to your investments; successful investors know the importance of keeping their emotions and finances separate. It also lies in knowing when an investment is no longer working in your favour and cutting your losses at the right time to prevent further loss.
One well-tested way to instil discipline is to include a stop-loss (pre-set level) to sell an investment if its price drops below a certain amount.
4. Recency Bias
Beware of recency bias – placing too much emphasis on experiences that are freshest in your memory. This is especially important following periods of strong or poor performance. Recency bias may lead investors to think that a current stock market sell-off or rally will extend into the future, and can lead investors to make short term decisions that are not aligned to their long term financial plans. This can have detrimental consequences on their wealth.
An example of this is the market rally in 2021. Equity markets surged following the Covid outbreak. So-called ‘Meme’ stocks gained viral popularity through heightened social sentiment, and rallied strongly, despite the fact that they had little revenue and very high multiples. The risk/return trade-off became very high as these stocks rallied and became more and more expensive. Despite this, many investors continued to buy them, ignoring conventional fundamental valuation metrics, believing that, because the stocks had rallied and had strong popularity, that they would continue to rally. Sadly, many investors suffered extreme losses as these ‘meme’ stocks plummeted in late 2022.
The same can be said for market sell-offs. With 2022 delivering one of the worst returns across all asset classes in decades, many investors may be wary of investing, despite fundamental valuations looking attractive. It is important to be aware of recency bias when focusing on your portfolio. Ensure that you assess investment opportunities on their fundamental merits, not based on past performance.
5. Familiarity Bias
Familiarity breeds comfort, and as investors, it leads towards familiarity bias when seeking to invest – be it in a company, sector, region, or country. For one, employees show a bigger preference to invest in their company’s stock. They could, however, be at risk of two losses if the company performs poorly – loss of compensation as an employee and loss of investment gain as an investor.
Another example is only investing in stocks of your local country. You might be comfortable with local company brands, or local company services so you then choose to only invest in these companies as you are familiar with them. However, this exposes you to concentration risk, resulting in less optimal portfolios and under-diversification.
Navigate familiarity bias by gradually diversifying your investments more broadly across companies, sectors, countries, and regions. In doing so, you can reduce your portfolio’s risk and smoothen out your returns.
6. Bandwagon effect
A person who practices the bandwagon effect finds the odd comfort of participating in something many others have done. However, in the investment world, following the crowd could lead to bad investment decisions.
As an example, investment price bubbles can happen, where the price of a particular investment asset rises continuously. When more people rush in to buy the asset, its price could go up further, creating a loop of rising prices and an increased demand for the asset. Eventually, it can get to a point beyond any backing by the fundamentals and become highly overvalued.
It’s always best, therefore, to analyze and decide based on your own research and strategy before proceeding with any investment. Think of the long term instead of short term trends and market sentiment. You could also explore investing in undervalued assets that may offer better returns compared to popular investments, despite being the underdog in the market. With these strategies, you can prevent falling into the trap of ‘herd mentality’ bias and increasing the odds of drawing sound conclusions based on information and insights.