Are behavioural biases affecting your decision-making?
Please note: The article does not constitute advice or any form of investment recommendation.
The emotional highs and lows of investing
As human beings, we tend to experience a predictable pattern of emotional responses to perceived successes and failures, which includes financial gains and losses.
When it comes to investments, this behaviour can potentially prevent us from achieving our goals if we fail to recognise the relationship between our emotional responses and our decision-making.
During periods of elevated stress, our cognitive biases – deviations from the norm or rationality in the way we process information – often become more pronounced. Investors may be tempted to buy when markets are strong as they gain greater emotional reassurance from this course of action.
Likewise, they may seek psychological shelter by selling near market lows. While comforting in the short term, these knee-jerk reactions could lead investors to miss out on the benefits of remaining in markets over the longer term.
Humans typically experience more extreme emotional responses to losses than to gains of an equivalent value. If we view financial markets solely through the lens of our losses, we could be prone to taking more extreme actions in an attempt to minimise our losses. Often, we may not thoroughly consider the long-term implications of these decisions.
Emotional control helps financial control
Understanding your psychological responses, and factoring these into your thought processes, could help you make more considered investment choices and achieve your performance objectives.
Although we believe that ‘loss aversion’ is the most significant behavioural bias, this is far from the only psychological factor that can impact investors.
In this article, we explore four other ways in which your psychological biases could sway your decision-making, and provide ideas for maintaining objectivity.
1. Confusing emotional and financial worth
Under the concept of ‘mental accounting’, people assign an increased value to certain pools of money, according to their designated use and how the funds were acquired. We might, for example, attach a higher significance to money intended to help our children get on the property ladder, or to money inherited from a deceased relative.
Although allocating money to certain expenses can be useful for wealth planning, there are potential downsides to this approach.
If, for example, an investor holds too great a portion of their funds in cash during periods of high inflation (such as the one we are currently experiencing), the real-term value of their savings can decrease significantly.
Money itself is interchangeable. It is our emotional attachments that lead us to allocate funds for a particular purpose. Looking at the bigger picture of your finances can give you a broader vision of the opportunities (and risks) for your wealth.
2. Fixating on arbitrary events
As with many things in life, our past experiences of investing can inform our behaviour in the present. The ‘anchoring effect’ is a psychological bias whereby people fixate on a previous experience and allow this incident to exert an undue influence on their thought processes.
Human nature also means that we may place too great an emphasis on the first piece of information we receive about an event, even if it is no more authoritative than subsequent data.
The anchoring effect can lead investors to fixate on a recent high in the markets as a reference point when drawing comparisons. You might, for example, feel anxious to discover that your portfolio has fallen a certain percentage from a recent temporary high.
When selling property, there is also a tendency to use its initial purchase price as a guide when considering an offer from a potential buyer, without factoring in changes in the real estate market that could impact its current value.
Once investors are aware of the psychological sway of the anchoring effect, they can mitigate its influence by focusing on their future objectives. The longer you are in the market, the less important temporary highs become.
3. The appeal of the familiar
From a psychological standpoint, ‘confirmation bias’ is the tendency to search actively for information that reaffirms our existing views.
This tendency also compels us to hold such information in higher regard than seemingly contradictory facts, and to recall it more readily than other details that do not align with our beliefs.
Consider a bullish investor who is deciding how to position their portfolio. This individual may place a particularly high value on encouraging headlines about financial markets, while disregarding negative developments in the global economy.
Confirmation bias can result in investors holding portfolios that are not sufficiently diverse, which leaves them more at risk from unforeseen events in certain sectors or geographies.
When reading or watching financial news, try to consider all perspectives carefully, and especially those that contradict your own point of view. By doing so, you are less likely to be blindsided by an event beyond your usual frame of reference.
Also, be aware of the powerful sway that market narratives can hold over investors. From an emotional perspective, many people find narratives appealing as they feel familiar and reassuring. This is especially true if facts appear to validate what the narrative is telling us.
Once we have convinced ourselves of the truth of a narrative, it can be difficult to step back and reassess a situation. To avoid falling into this trap, it is helpful to constantly question the bigger picture behind what might, at first, appear to be compelling story.
4. Losing objectivity over past events
‘Hindsight bias’ is a bias which leads people to convince themselves retrospectively that they would have anticipated a difficult-to-predict event. Take the example of a football game or job interview – it is far easier to identify the early signs of the eventual outcome once the event has played out.
With the benefit of hindsight, our memories often bring to the fore details that support the actual result, rather than any information that may have indicated an alternate outcome. Relying on these biased recollections, we may tell ourselves that we had foreseen the result from the outset.
This heightened sense of self belief may cause investors to make future decisions without factoring in all relevant data. Conversely, hindsight bias can also cause investors to be overly critical of themselves for not positioning their portfolios in anticipation of an event they failed to predict.
It is important for investors to remember that many events are extremely difficult, or near impossible, to foresee. The wisdom that “it’s not about timing the market, it’s about time in the market” may be well-worn, but it remains as relevant as ever.
Confront, and conquer, your biases
While the impact of these four behavioural biases is impossible to deny, the extent to which we are personally affected will depend on factors such as our psychological make-up and previous experiences of investing.
By recognising your biases and their possible impact on your decision-making, you could be better placed to overcome them. One way of achieving this can be by working with experts who will challenge your preconceptions and lead you to a more objective mindset.
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