Investing is a journey, but the course of your journey can be easily derailed if you succumb to your emotional biases.
Investing can be an emotional activity, and their influence can lead investors to make irrational and inappropriate investment decisions. Emotional biases are those driven by impulse, intuition and feelings, rather than choosing to follow sound investment principles, and can create blind spots that result in undisciplined investing. Let’s examine some common emotional biases that can plague investors:
Many investors tend to over-estimate their investment expertise or forecasting skills which can lead to what is referred to as the ‘over-confidence’ bias. This bias can result in over-trading or blind spots when it comes to identifying potential risks in one’s portfolio. In addition, investors who succumb to this bias often take credit for investment gains on the one hand, while blaming external factors for any investment losses – which, in turn, can result in them making even more over-confident predictions, leading to losses over the long-term.
In simple terms, the unhappiness of losing money is felt more deeply that the happiness of gaining the same amount of money, and this bias is referred to as ‘loss aversion’. Where markets are downturned, many investors choose to leave their money in cash in order to avoid possible losses but, in doing so, regularly miss out on the gains that can be made when the markets turn. The emotional anxiety experienced by some investors when markets generate poor returns is essentially felt more deeply than the equivalent gains made when markets are upturned and, by choosing to avoid the losses, many investors also miss out on opportunities for investment wins.
Illusion of control
Investors, particularly online investors, who try to time the markets are demonstrating textbook ‘illusion of control bias’, believing that they can control – or at least influence – the outcome. Illusion of control investors tend to trade more frequently and hold less diversified portfolios, tending to opt for those shares that they believe they have an element of control over, albeit illusionary. Such illusion of control can lead to investor over-confidence, excessive trading, poor market timing and ultimately poor returns.
Investors succumb to ‘representative bias’ when they arrive at a conclusion based on what they believe the facts suggest or represent, rather than investigating deeper. For instance, you may want to invest in a particular company’s shares because you believe from its marketing pitch that it is an ethical company rather than actually researching its ethics. Just because a company markets itself as ethical and possibly sells higher quality products, it is not to say that buying shares in the company is a sound investment decision.
Investors who make investment decisions on the basis that ‘everyone else is doing it’ are succumbing to what is known as ‘herd bias’, choosing to believe that ‘everybody can’t be wrong’. This groupthink bias operates on the basis of safety in number where investors take comfort in the fact that everyone is jumping on the same bandwagon. Investing in a share because everyone else is doing the same is fundamentally flawed decision-making, primarily because the decision is not based on research but on the actions of the collective.
Many people who live beyond their means are in effect demonstrating a ‘present bias’ – believing that spending money in the present is more important that putting money away for future financial security. The tendency with this bias is to focus on the present by over-valuing the immediate rewards rather than focusing on the longer-term rewards, even if they are more favourable or beneficial than the immediate one.
‘Self-control bias’ is essentially a lack of self-discipline which leads investors to compromise their financial futures and often occurs in conjunction with present bias. Those who lack self-control find it difficult to delay gratification in the present in favour of securing a comfortable financial future. This bias often results in investors taking on too much risk in their portfolios in order to generate higher returns and can result in them being under-funded for retirement.
‘Endowment bias’ is the idea that something we own is more valuable than something we do not. As humans, we are hardwired to avoid making losses to the extent that we will hold onto something that we own even if we are losing money by doing so. This is known as loss aversion, or the endowment bias, which leads us to place greater value on things that we own – including shares – than things that we don’t. From an investment perspective, the endowment bias is difficult to overcome because the investor made a conscious decision to invest in a particular share or strategy and, even if the strategy is a loss-making one, the investor may refuse to change strategies in the hopes of making their money back. This bias can result in investors missing out on excellent investment opportunities while their money is tied up in loss-making funds.
Sometimes referred to ‘analysis-paralysis’, many investors avoid taking any decision at all for fear of making the wrong decision. Rather than live with the regret of following a particular course of action, some investors err on the side of doing nothing at all. ‘Regret-aversion’ bias, whether an error of omission or commission, and ‘herd bias’ often go hand-in-hand where an investor chooses to follow the crowd rather than live with the regret of not doing so.
Status quo bias
The ‘status quo bias’ often occurs together with regret aversion, where an investor chooses to maintain his investment status quo rather than change investment strategy. This can result in an investor remaining invested in a portfolio that is beyond his propensity for risk or one that is no longer aligned to his investment objectives. Investors often feel more comfortable keeping things as they are rather than considering alternative investment strategies that may be more beneficial to them and more aligned with their objectives.