While we all know that successful long-term investing requires that we adhere to our investment strategy and ignore our emotional responses to short-term market noise, the reality is that retaining composure in the wake of events such as Russia’s invasion of Ukraine, local political instability, the continued reality of load shedding, and the emergency of the fifth Covid-19 wave is hard. Fear, greed and exuberance, to name just a few emotions, can override our discipline and scupper our chances of building long-term wealth.
In this article, we explore seven emotional biases and how they can wreak havoc on one’s investment portfolio.
Recency bias, also known as availability bias, happens when investors place too much emphasis on new information or events and use that information as the basis for making investment decisions. In essence, investors use the most recent information (or information that just happens to be top-of-mind) without rationally assessing the probabilities over the longer term.
The problem with recency bias is that investors rely on short-term information when making investment decisions or when rebalancing their portfolios rather than looking at long-term performance and/or data – such as only taking the last 12 months of a fund’s performance into account and ignoring the real returns achieved by the strategy over the longer-term.
Investor behaviour in response to the Covid-19 pandemic in early 2020 provides an excellent example of recency bias in action when many investors chose to exit the markets in a panicked reaction to uncertainty and fear. In doing so, they failed to take into account the long-term historical returns of the stock markets and the market’s proven ability to bounce back – thereby unnecessarily locking in their losses. Those who ignored their recency bias by focusing instead on the market’s proven track record were rewarded when stock markets predictably recovered.
As with all biases, recency bias is not confined to the stock markets only, but rather forms part of our everyday life. For instance, our fears in respect of crime are very often driven by the most recent crimes reported in the news rather than by the probability of that particular crime happening to us, or whether we’ve been a victim of that type of crime in the past.
Anchoring bias in the context of investment often happens when investors place too much importance on the initial information they received, creating a psychological benchmark or reference on which all future decisions are made.
Anchoring happens to us all the time, especially in the retail industry. Retailers rely heavily on consumers succumbing to this bias particularly when it comes to sales. For instance, in the build-up to Black Friday, a retailer might set a price point for a particular product which then creates a benchmark in the consumer’s mind in terms of the product’s value. When the product’s price is discounted for the Black Friday sale, the consumer will consider the sale price of the product against the original price point set by the retailer rather than doing due diligence on the actual value of the product. The more prominent the anchor price is, the more a consumer may tend to cling to it – a phenomenon that plays out particularly well in the online retail space.
When it comes to investing, an investor may find themself emotionally anchored to the price that they paid for a particular share and, instead of selling the share, may hold onto the share in the hopes that it will return to its purchase price. In essence, the purchase price of the share becomes a fictitious reference point on which the investor relies when making decisions to sell or retain the share.
Endowment bias occurs when a person perceives something to hold more value simply because they own it. One only has to visit Facebook Marketplace to find examples of endowment bias at play, especially when it comes to the selling of antiques, heirlooms and artwork. Owners of such items often tend to overprice their products because they perceive more value in the item than it actually holds in the marketplace.
Investors who succumb to endowment bias may perceive a share to hold more value than it actually does and, in turn, hold onto the share for too long rather than realising it for a realistic profit. Many property investors fall prey to endowment bias in that they perceive their property to hold more value simply because they own it. This often results in property owners rejecting reasonable offers to purchase and missing the opportunity to sell the asset for a fair price.
Those who succumb to endowment bias often have an emotional attachment to an asset and, as such, are unable to make rational decisions. This often happens in the case of inherited assets or assets which have been passed through generations.
Status quo bias
Generally speaking, people tend to avoid change and opt for maintaining the status quo – choosing to do things as they’ve always been done rather than go down the path less travelled. Sticking with familiar territory is more comfortable than making tough decisions, especially when it comes to money – bearing in mind that choosing not to make a decision is a decision in itself.
Most of us tend to give in to status quo bias as we move through our daily lives, choosing the tried-and-tested option on the restaurant menu, reading the same authors, listening to the same rock bands, wearing the same brands, and travelling the same routes that we have grown accustomed to.
In the context of investing, an investor may find themselves reluctant to make changes to their portfolio, preferring to maintain the status quo which, in turn, may result in them holding onto a portfolio that is no longer aligned with their investment goals or risk tolerance.
The mere fact that so many people fail to save for their retirement is indicative of how prevalent the self-control bias is. While most people know that they need to put money away for their future, very few actually take steps to invest in their future selves. When faced with choosing between what they want now versus what they want more, many demonstrate a lack of self-discipline by succumbing to instant gratification. This type of bias often trips people up when trying to stick to a healthy eating plan or commit to regular exercise, where the small payoffs in the present are favoured over longer-term gains.
This type of bias can cause numerous problems in the context of investing, especially where an investor has delayed funding for the future. In attempts to play catch-up, an investor may be forced to take on more investment risk than they are comfortable with or end up with an inadequately diversified portfolio which places emotional strain on the investor. Searching for short-term gains can also drive investors to speculate rather than adhere to a longer-term investment strategy.
Having a comprehensive retirement plan developed is a powerful tool which may help investors retain focus on how much they need to save and the most appropriate levels of risk for their needs.
In general, people experience more pain over losing money than they do pleasure in gaining the equivalent amount, and this is known as the loss aversion bias. This type of bias is characterised by an investor’s fear of losing money and avoiding financial loss at all costs. This bias is based on the psychology that the pain an investor experiences when losing money is twice as powerful as the pleasure they feel when they experience 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. This type of bias is often at play in game shows such as Who wants to be a millionaire where a participant would choose to bank the gains already made rather than risk losing on the next question.
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.
Overconfidence bias is something that many of us succumb to by overestimating our skills in a specific area such as our driving skills, our ability to gauge how long a task will take to complete, or our ability to manage our own finances. Overconfidence bias is highly prevalent amongst investors and is often ego-driven, with investors overestimating their ability to analyse information, identify new investment trends, and choose stocks. It can also lead investors to overestimate their propensity for risk which, in turn, can lead them to make irrational decisions during times of short-term market volatility.
When losses arise as a result of overconfidence bias, an investor’s psyche and self-esteem may be affected which may impact their future decision-making. In financial planning, many people tend to overestimate their own ability to manage their financial affairs which often results in financial loss in the form of excess investment fees, higher tax liabilities, and other avoidable costs.
Regret aversion bias
Investors who suffer from regret aversion bias are so fearful of making an incorrect decision for fear of incurring losses that they elect to do nothing instead. In other words, they fear that they will live to regret the decision because they will struggle emotionally to live with the outcome.
That said, regret aversion can cause investors to worry about making an error of omission, such as not buying a particular share, or fearful of making an error of commission, such as buying a particular share in the hopes that it will increase in value whereas it does not. Another example would be where a property investor does not want to admit that their property investment was a poor one and they spend more time and money on trying to enhance the value of the property rather than living with regret over the decision to buy the property in the first place. Regret aversion can often result in what is often called ‘buyer’s remorse’.
Having had a closer look at the various emotional biases we, as investors, may be susceptible to, it’s important to remember that not all emotions are bad. We may, for instance, have strong feelings about the values and/or ethics of a company or industry which may impact our investment decisions.
What is important is to be able to recognise which of our emotions are at play and to determine to what extent those emotions are affecting our ability to rationalise and objectively analyse information.