Four psychological biases investors must understand

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Concept of stress with gear in the head of a businessmanIn our last post we highlighted that behaviour might just be the biggest source of trouble for investors.  People just aren’t psychologically wired to make investment decisions that are good for them and often do things that are potentially harmful.

Our brains have evolved to create protection mechanisms that in many instances are helpful – just not when it comes to investing!  The subconscious creates short cuts designed to save us time when making decisions and to protect us from pain, both emotional and physical: basically, these short cuts help us perform better in “fight or flight” situations.  While many of these biases and their implications for investors have been documented by the likes of Daniel Kahneman, Amos Tversky and others, we think the following four stand out:

1.) Familiarity Bias

We tend to stick with what we know, whether that is products we buy, places we frequent or stocks in which we invest.  Presumably this heuristic evolved over time to help us make quicker decisions and keep us safe but when it comes to investing it can have the opposite effect.  For example Canadian investors tend to overweight their portfolios towards Canadian stocks, a common phenomenon globally but Canadians are among the most extreme examples of what’s known as “home bias.”

While Canadian investors might feel more comfortable owning the shares of companies they read about in the news most often and that are closely tied to our own economy, from an investment perspective they are taking on unnecessary risk by being overly exposed to specific companies in the oil, mining and financial sectors.  Canadians would be better off from a risk and reward perspective if they were to diversify more outside of Canada.

2.) Recency Bias

We tend to remember things better that happened more recently than we do things that occurred further back in time.  If you look at expert forecasts from Wall Street analysts going back in time, they tend to forecast very high returns just at or following market peaks (like the internet bubble) and low returns following market bottoms (like during the 2008/2009 financial crisis): clearly not very helpful and if so-called experts fall victim to the same biases, what chance do the rest of us have?  Markets are volatile and move in cycles:  anchoring on recent trends or sentiment might lead us to make decisions that result in the opposite of what’s good for us.

3.) Overconfidence Bias

Daniel Kahneman believes this to be the most dangerous of all behavioural biases and the most difficult to overcome.  Just like driving ability, people tend to believe they have a better than average ability to pick outperforming investments or investment managers.  This bias leads people to ignore overwhelmingly convincing evidence, often at their peril.

For example, despite the fact that data shows that paying high fees for active investment management leads to lower returns on average and greater uncertainty of outcomes, people continue to try to beat the market or find winning investment managers.  (Full disclosure, Chalten Fee-Only Advisors espouses an evidence-based low-cost, largely passive investment philosophy!).

4.) Herding

It’s a lot more painful to be wrong on your own than be wrong when everyone’s wrong.  Surely the herding mentality stems from some innate desire to feel included, to avoid being exposed whether right or wrong.  The result of herding in the investment world is that once trends develop there tends to be a “bandwagon effect” that becomes difficult for many investors to resist.  “Fear of missing out” or FOMO as it’s popularly acronym-ed these days can drive individuals to make irrational investment decisions they might normally avoid if deciding independently.

The net effect of the above is that people make investment decisions that are harmful.  Often the result is that investors buy into euphoric market peaks and sell out at the bottom of market panics.  It is no surprise that studies show that investment returns earned by individual investors are not only lower than market index returns but lower than those of the mutual funds in which they invest: investors just get in and out at the wrong time.

And if it’s not enough of a struggle that we have these psychological biases to battle against, most of the financial media and investment industry use communication and advertising practices that are specifically designed to exploit all of our psychological pitfalls!

How can you win?  To begin with, develop a investment plan that fits in with your overall financial plan.  Define parameters that address your ability, need and willingness to take risk and then use your plan as an anchor (in this case an anchoring bias is OK!) to keep you on track and avoid being swayed by both external noise and internal psychological biases.

graham-bodelGraham Bodel is the founder and director of a new fee-only financial planning and portfolio management firm based in Vancouver, BC., Chalten Fee-Only Advisors Ltd. This blog is republished with permission: the original ran on September 14th on Bodel’s blog here.  

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