Overcoming behavioural biases in investing

Investors naturally expect their efforts to generate financial rewards, however investing is not without its potential downsides. Perhaps not widely known is the fact that investment decisions can be impacted negatively by what are known as behavioural traits. These traits are not based on rational considerations. What follows are a few examples of this phenomena and the means of minimising their impact.

Confirmation bias

This is where investors look to find evidence which backs up their originally held views, while turning a blind eye to evidence pointing in the other direction. Such behaviour can result in mistaken views and faulty investment decisions, driven by emotions. For example, someone who views a particular equity as being undervalued may look for news or research which backs this belief and pass over any contradictory news or research which might challenge this.

To manage this bias, investors should search for a wide range of news and research and not unfairly dismiss, ignore, or otherwise overlook anything which tests their considered views and opinions.

Loss aversion

This is where investors very much favour avoiding losses over achieving similar sized gains. In doing so, this can mean that investors concentrate more effort conserving capital values than they do on looking for possible positive returns. For example, investors holding onto certain equities for longer than they should, simply not to have to turn a paper loss into a real loss and redeploying resources elsewhere.

This course of action often results from an unwillingness to accept that losses are a natural part of the investment process. Investors should construct and regularly maintain (or have one constructed and maintained on their behalf) a suitably diversified portfolio, based on their Attitude to Risk and Capacity for Loss.

Herd mentality

This is where investors follow the crowd and make investment selections based on the decisions taken by others, as opposed to carrying out their own research. Such behaviour often results in investing in over-valued equities or selling off under-valued stock without realising what they are doing. The dot-com bubble of the late 1990s was a great example of this.

The solution, again, is for investors to construct and regularly maintain (or have one constructed and maintained on their behalf) a suitably diversified portfolio, based on their Attitude to Risk and Capacity for Loss. Additionally, they should steer clear from impulsive behaviours in their decision-making process.

Overconfidence bias

This is where investors are inclined towards holding an exaggerated view of their investment skills. In turn, this results in them taking too many risks, believing as they do, that they possess the superior skills or insights that will deliver superior returns. Often this comes about because a new investor enjoys initial success and then becomes over-confident and takes less well researched decisions.

Implementing appropriate investment processes, should manage the risk and poor outcomes which stem from overconfidence.

Further behavioural biases include:

Familiarity bias

This is where investors focus on areas they are familiar with, or believe are good quality, as opposed to a adopting valuation basis approach to investment.

Anchoring bias

This is where investment decisions are based on earlier news or research and interpreting new information around that anchor. A simple example of this is the decision to sell a stock based on the original purchase price.

Mental accounting

This is where investors pigeonhole investments in ‘different accounts’ and treat them differently.

Gambler's fallacy

This is where decisions are based on the belief that in many areas of life, a long-term average applies, including that of share prices. The Gamblers Fallacy is the idea that a movement away from a long-term average of a share price, will correct itself over time. Meaning that the price of that share will inevitably move back towards its long-term average.

Conclusion

As I hope you can see, behavioural biases do seriously affect the outcomes investors enjoy, sometimes in a negative way. Central to the task of managing these human behaviours is to remain objective, carry out extensive and exhaustive research and build controlled decision-making strategies.

By employing the services of Dentons Wealth you would enjoy the advantages and benefits associated with expert investment management through a service that manages the investment process from the beginning to the end. Investors should look to invest for the long-term and not let the short-term news or underperformance, drive decisions and detrimentally effect investment decisions.

If you want to discuss any of the issues raised in this article, please contact your usual Dentons Wealth Independent Financial Adviser.

Although every effort has been made to ensure that the information provided in this article is accurate and correct, the information provided does not constitute any form of financial advice. We recommend that you take financial advice before making any financial decisions.