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8 August 2023

Overcoming Behavioural Biases

News & Insights

Liz Schulz

Investing can be a highly rewarding endeavour, but it’s also full of risks and challenges. A significant factor that can impact decisions is the behavioural traits that investors can be swayed by. As such, the decision making process is not always led by rational considerations. Hence, biases can significantly impact outcomes. With input from our investment partners, LGT, below are some common behavioural biases that affect investors, along with real-life examples of these biases, and how to be more aware of them to limit their impact.

Confirmation bias

Confirmation bias occurs when individuals seek out information that confirms their pre-existing beliefs while ignoring contradictory evidence. When investing, this bias can lead to a skewed perspective and poor decision-making, influenced by emotions. For example, an investor who believes that a certain stock is undervalued may actively seek news or research that supports this belief, ignoring any negative signals that may suggest otherwise.

To overcome confirmation bias, it’s important to actively seek out diverse perspectives and information that challenges your existing beliefs. Engage with different sources of information, consider alternative viewpoints and maintain a healthy scepticism towards your own assumptions.

Loss aversion

Loss aversion refers to the tendency of individuals to strongly prefer avoiding losses over acquiring equivalent gains. This bias can result in overly conservative investment decisions, as investors focus more on preserving their capital than on pursuing potential gains. For instance, an investor may hold onto a losing stock for too long, hoping to avoid realising the loss, instead of cutting their losses and reallocating their capital elsewhere.

To prevent this, we must recognise that losses are a natural part of investing and embrace the concept of risk. You must establish a well-diversified portfolio that aligns with your risk tolerance and investment goals. Then regularly review and rebalance your portfolio to ensure it remains aligned with your long-term strategy.

Herd mentality

Herd mentality occurs when individuals follow the crowd and make investment decisions based on the actions and opinions of others, rather than conducting their own independent analysis. This bias can lead to overvalued or undervalued assets as investors pile into or flee from certain investments without a thorough understanding of the underlying fundamentals. A famous example is the dot-com bubble of the late 1990s when investors followed the hype and poured money into technology stocks that were fundamentally overvalued. A more recent example would be the GameStop bubble of 2021 fuelled by retail investors on Reddit.

To correct this, one must take the time to conduct their own research and analysis before making investment decisions. Avoid making impulsive choices based solely on market trends or popular opinions. Be patient and rely on your own judgment to identify sound investment opportunities.

Overconfidence bias

Behavioural finance has its roots in psychology and Kahneman’s book Thinking fast and slow (2011) believes humans make decisions using two ‘systems’ that operate for different purposes and at different speeds. System one is thoughtless and acts instantaneously based on human emotions. Whereas system two is more rational and analytical, used for reading poetry, for example. Humans mostly use system one, with system two ‘monitoring’ in the background. The psychological bias, overconfidence, originates from the unconscious actions of system one and is possible to control, but not eradicate.

Overconfidence bias refers to an individual’s tendency to overestimate their own abilities and knowledge. This bias can lead to excessive risk-taking and overtrading, as investors may believe they possess superior skills or insights that will consistently generate above-average returns. For instance, an inexperienced investor may have initial success with a few trades and become overconfident, leading them to make riskier and less researched investment decisions.

Practicing disciplined investing strategies, such as diversification and long-term investing, is a sure-fire way to control the risks associated with overconfidence, along with continuing to learn and develop your knowledge.

Other common heuristics, or rules of thumb, include:

  • Familiarity bias can be explained by the home bias or quality bias – investing in assets/markets we are familiar with or consider good quality/brand names, rather than because valuations tell us to.
  • Anchoring bias is setting an anchor based on some early piece of information/reference and interpreting new information around that anchor. For example, whether people sell shares is influenced by what they paid for them.
  • The gambler’s fallacy has echoes of the widespread belief in mean reversion. Mean reversion refers to the idea that an extreme movement away from a long-term average or norm in some activity, such as the performance of an asset market, will tend to correct itself in time, and that the activity (or the price) will eventually move back towards the mean.
  • Mental accounting is where people place investments in ‘different accounts’ mentally and treat them differently.

Behavioural biases can significantly impact investment decisions and hinder investors from achieving their financial goals. The key to overcoming these natural behaviours is to remain objective, conduct thorough research and develop disciplined investing strategies.

By investing with Five Wealth, you have the benefit of an Investment Committee that self-monitors and has diversity of thought. It is important to invest for the long-term and not letting the herd, short-term news or underperformance, drive decisions and detrimentally influence investment decisions.

If you would like further information on anything covered in this article, please get in touch via the contact page.

* Investments carry risks. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.