We all like to think we’re rational people, especially when it comes to our financial decisions.
But despite our best intentions, every investor on planet earth suffers from a terrible shared affliction with the potential to cost us big. We’re human – which means we’re fallible.
Which is why more and more attention is being paid to the role of behaviour in investment decision making.
Borrowing from the fields of psychology, sociology and neuroscience, the rapidly developing discipline of Behavioural Finance is illuminating the once nebulous area of financial decision making. And with it, the often easy ways to avoid pitfalls we can all fall into.
Here are five mental biases to consider:
1. Following the herd
When the Shanghai Composite Index began to soar at the end of 2014, investors were quick to follow the herd of speculators before them and invest to take advantage of rising prices.But the artificial inflation couldn’t last forever.
Having risen 100 per cent in just eight months, by June 2015 the market began to overheat. The bubble abruptly burst, wiping out more than $3.2 trillion of shares and sending shockwaves through the global economy.
Lesson: Just because everyone else is doing it, doesn’t make it a good idea. In fact, doing the opposite – known as contrarianism – can often be a better approach.
2. Becoming a prisoner to loss aversion
We’re hard-wired to feel losses more than we feel the benefit of gains. So we tend towards investment strategies with the lowest risk of short-term losses rather than those which offer the greatest potential for long-term gains.
As a result, investors often sell their winning positions too early to avoid falling into a loss position, but in doing so sacrifice the prospect and real chance of making bigger gains.
Lesson: Analyse the long-term returns of different investments first and avoid short-termism.
3. Confirming your existing opinions
In psychology, Confirmation Bias explains the human tendency to search for information to back-up our existing beliefs, rather than looking at alternatives which challenge them.
As investors, this means once we’ve decided to invest in emerging market stocks, for example, we will actively seek out the data to confirm our decision without stopping to question it and consider the risks of investing in volatile less familiar markets.
Lesson: Actively argue against your first instinct and reach a more balanced conclusion.
4. Acting for the sake of acting
When faced with a difficult investment choice – for example two equally promising, but risky, assets, our minds have an unhelpful habit of telling us it’s better to do something rather than nothing. Even if it poses a risk.
In certain market conditions, it is better to avoid making active stock selection decisions and invest passively instead.
Lesson: Sometimes doing nothing is the most appropriate course of action.
We’re all guilty of reaching for the stars. It’s a charming human trait, but it’s also been the undoing of many an experienced investor.
Despite developments in forecasting financial markets, however experienced an investor you are, it remains impossible to predict the future. There is no such thing as ‘a sure thing’.
Lesson: The only thing that’s certain is uncertainty. Accept the unknown unknowns and spread your risk across a broad portfolio.
Behavioural Finance offers the key to understanding why investors make the decisions they do. By using it to avoid our inbuilt biases we can make better decisions, and more profitable investments.
This article was originally published by the Centre for Accounting and Society.
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