Cognitive and emotional biases may result in poor investment decisions.
As humans, we are predisposed to several cognitive and emotional biases especially when it comes to investing. Investor behaviour is not always rational because these biases cause us to make poor investment decisions which, in turn, lead to poor investment outcomes.
The surest way of avoiding your biases is to understand them, both in the context of investing and in everyday life.
Loss aversion is characterised by an investor’s intense fear of losing money and not wanting to accept a financial loss. It is an emotional bias that is based on the psychology that the pain an investor experiences when losing money is twice as powerful as the pleasure he feels when he experiences investment gains. While all people react differently to positive and negative changes, those who suffer from loss aversion assign more significance to a loss than if they were to earn the equivalent gain. For a person with loss aversion, they would prefer not to lose R100 than to find R100. Loss aversion causes investors to trade too frequently which in turn affects their investment returns. They generally end up either selling their stocks too early or holding onto them for too long.
Everyday life example: ABC company emails you a ‘25% off today only special’ on a flat-screen TV. Even though you don’t necessarily need a new TV, you decide to buy it anyway because the thought of losing out on the deal provides strong motivation to rather buy the product. The thought of losing out on such a great discount is simply too much to bear. Retailers play on loss aversion biases all the time to get us to spend.
Investors who suffer from an over-confidence bias tend to overestimate what they know and what they are capable of doing. They believe they know more about trading than the average investor – not only in terms of information but in respect of getting their timing right. This bias is not restricted to the investment arena and can be found in almost every area of life. For example, a recent survey in the US found that 93% of Americans believe they are above-average drivers. Investors who have worked in the IT industry may, for example, demonstrate overconfidence in their ability to predict what will happen with tech shares simply because they have industry experience. This bias can lead investors to trade more often and fail to adequately diversify their portfolios as a result of their over-confidence.
Everyday life example: You and your husband go on a long trip. Your husband is overconfident in his sense of direction and ability to navigate and leaves his map and GPS behind. He falsely believes that his ability and knowledge exceeds that of both the map and GPS combined.
Confirmation bias is a cognitive bias that causes investors to actively look for information that supports their decision. For example, an investor may believe that cannabis shares are the next big thing and actively seeks out information that supports his opinion. Instead of looking at the matter objectively, he will selectively filter all information and pay more attention to the information that supports his belief. An investor with confirmation bias is more likely to buy and sell shares at inopportune times, placing his investments at risk. His investment decisions are not made objectively, but rather through a process of filtering and handpicking information that supports his decision.
Everyday life example: You have always been told that left-handed people are more creative than right-handed people. When you meet a left-handed artist, you use this as ‘evidence’ to support your belief. You might even seek out other information to prove your belief while discounting evidence that does not support it. Another good example is that of US President Donald Trump. Your opinion of Donald Trump is likely to determine whether you watch the news on CNN or Fox News, with most people tending towards the news channel that is most likely to support your opinion of the man.
Also known as ‘focalism’, this bias causes investors to become too heavily dependent on the first piece of information they acquire. Once the value has been set – or anchored – in the investor’s mind, all other information is processed with this value. Many investors who succumb to an anchoring bias hold shares that have lost value longer than they should as they wait for the share to return to its ‘anchor price’. As such, they can end up taking more investment risk than they need to or should.
Everyday life example: You are shopping for a new pair of jeans and find a pair that you like at Shop A for R1 000. You then go to Shop B and find a pair of jeans for R300. You are likely to consider the second pair of jeans as being ‘cheap’ because your reference point is anchored at the price of the first pair of jeans.
The herd instinct causes investors to follow what they believe other investors are doing, rather than undertaking their own analysis and research – a bit like a ‘safety in numbers’ approach to investing. In many instances, investors fall victim to a herd instinct for fear of missing out on a good investment. The herd mentality causes investors to gravitate towards the same type of investments because ‘everyone is doing it’ rather than it is a well-researched investment option. Large market rallies and sell-offs are often a result of the herding instincts of a large community of investors, despite a fundamental lack of justification to support their decision.
Everyday life example: You and your friends go out for dinner. Restaurant A hardly has any customers in it, and you have not heard any bad reports about it. Restaurant B is full of customers and there is only one table left. You decide to eat at Restaurant B because everyone seems to be enjoying themselves and you fear missing out on a good evening.
Information bias is the tendency that many investors have to analyse information even if it is not meaningful. By their nature, investment markets are volatile and there is an enormous amount of information distributed every minute of every day – much of which is of no consequence to a well-diversified, long-term investor. If you are invested for the long-term and reviewing your investment portfolio quarterly, then daily share prices and commentary will not provide you with meaningful information. Even though a blow-by-blow share price analysis may be inconsequential to a long-term investor, information bias can cause him to sell excellent shares because the price has fallen, or to buy bad investments because the share price has risen.
Everyday life example: You are part of a large social media group and ask for advice regarding a healthy skincare regime for your teenager who has acne. Fifty members of the group share their skincare advice which ranges from homoeopathic remedies to homemade solutions. You analyse all the opinions and advice offered and choose the remedy that most members of the group support, whereas the most logical solution would have been to take your child to the doctor or dermatologist.