Human biases and making decisions

Behavioural investing and how to avoid human biases

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For decades, economists have been debating the effects of human emotion on our ability to make rational financial decisions. The argument goes that rather than basing our decisions on cold, hard calculations and logic to maximise our returns, our emotions get the better of us and cause instinctive and illogical behaviour. These are known as behavioural biases and they can influence any aspect of your life, from your relationships to your investing adventure. Here, we consider some common biases you can encounter as an investor, and ways to avoid them.

 

Common biases

Loss aversion
We all hate losing! Being loss-averse simply means you prefer to ‘play it safe’ and not lose something you already have, rather than risk what you have to acquire something new. For example, a football team down to 10 players may play defensively to avoid losing, instead of trying to win. In money terms, the pain you feel after losing cash can be greater than the joy of receiving a windfall. Loss aversion can be quite problematic in the investing world since it can push investors to act on impulse and panic sell when markets are performing negatively, rather than remaining calm and holding onto their investments in the hope of recovery over the long term.

 

Confirmation bias
It’s well known that you’re more likely to select a newspaper that mirrors your own political views. This is confirmation bias! You select information that confirms your opinions and ignore the rest. Prejudices can be hard to shake, but they can also potentially undermine your investing journey. If you allow confirmation bias to creep into your investment decisions, you can potentially ignore vital information about investments and markets and you could be in for a nasty shock if it turns out that you were misleading yourself.

 

Overconfidence bias
Being confident can help you get on in life, but too much confidence can be a bad thing in investing.  If you start overestimating your own judgement, you might overlook the warning signs and make rash decisions. Studies show that overconfident investors tend to pick fewer investments and trade more frequently, hoping they can beat the market. But this typically means putting their eggs in one basket and taking higher risk, as well as paying more in trading costs which eat into their overall returns.

 

Recency bias
If you’ve ever thought something is more likely to happen again because it happened just now, then you’ve been subject to recency bias. Casino gamblers who believe they’re ‘on a roll’ are a perfect example. They keep playing, convinced they’ll continue to make gains, and invariably, in the end the house wins. In the investing world, relying on past performance to predict how investments or markets might perform in the future could lead to similar misery.

 

Herd mentality
We are social animals and are often influenced by our peers. Herd mentality is about following the crowd, although – nowadays it’s more commonly known as FOMO (fear of missing out). Take Bitcoin for example. Success stories shared via social media and traditional news outlets played a key role in the crypto-currency’s price surging to a record $19,5111 in December 2017. End of June 2018, the currency’s value is down to $5,8991 providing investors with a costly demonstration of the dangers of mimicking others without proper research and consideration. If you want to know what all the fuss was about, you can learn more about bitcoin in our blog. 

1: Bloomberg data

 

Four tips for avoid behavioural biases

Do your research
If you’re doing the investing yourself, make sure you’re well prepared. Predicting the future is impossible, so forget about past performance, ignore your gut and do some research. You could analyse what’s happening in stock markets, read as many company annual reports as you can, find out what the experts are saying and keep one eye on the news.

 

Diversify your portfolio
Make sure your investment portfolio contains a varied range of investments from different markets or countries. Spreading your money across different assets and locations could help you reduce your risk by diversifying your investment portfolio. 

 

Think long-term
Investors should have a long-term vision. Holding onto your investments over many years should be a good way to ride out the ups and downs of markets and help your money flourish, thanks to the power of compounding. So, when markets are performing poorly, try to avoid letting your emotions take over. Instead, remain invested, ignore the noise and resist the urge to sell!

 

Let experts do the hard work
Another way to avoid behavioural biases in your investments is to let someone else do it for you! Thanks to technology, it’s now quick and easy to get investing experts to select your investments and manage your portfolio on your behalf. Not only do they have years of investing experience, they also use clever algorithms to crunch numbers and analyse trends free from human biases. They can then use these to help make decisions about how best to manage your money.

 

Please remember the value of your investments can go down as well as up, and you could get back less than invested.

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The comments and opinions expressed in this article are the author's own and should not be taken as financial advice from Wealthify.

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