Think Long Term to Achieve your Goals
We all have tendencies and biases that creep into our everyday lives, these apply to the investment decisions we make too. Understanding some of your behavioural biases can help you make better investment decisions and keep you from falling into some basic behavioural finance traps.
Over the past decade behavioural investing has become increasingly important. The concept gained prominence through the works of Daniel Kahneman (author of Thinking Fast and Slow) and Richard Thaler, winner of the 2018 Nobel Prize in economics and author of Nudge: improving decisions about health, wealth and happiness.
Understanding how personal behaviours can influence investment decisions can help you become a better investor.
One of the key differences between traditional economics and behavioural economics is a focus on the psychology of decision-making and the impact of behavioural biases.
What is behavioural bias?
When people make irrational decisions, it’s probably because of some human biases they have. These unconscious errors in our thinking can influence everything from the food we buy to the investments we make. Every day, behavioural bias has a huge impact in the world of finance. You might also hear it referred to as cognitive bias.
What is behavioural finance?
Behavioural finance is the idea that our biased behaviour can manifest itself in our financial decisions.
Our biases depend on several factors - like our tolerance for risk, when we need to see a return, and so on. The beliefs we have and the emotions we feel based on past experience will play a big role in the kind of investment decisions we make.
For example, if markets took a sudden tumble, what would your instinct be? You might decide to stop investing until things calm down, or you could panic and start selling. You could also see it as a chance to buy stocks at lower prices. The market event is the same, but your behaviour depends on your beliefs.
Understanding "Blink" and how it can hurt your pocket
Our brains make decisions in a world of limited and poor information. They are hard wired for quick pattern recognition and decisions made on the fly, referred to by experts as System 1 or "Blink". This has proved helpful for survival in the wild but is less useful in the world of investing. It can push us towards patterns that may not actually exist.
Five examples of behavioural biases in investment decision making
You should buy low and sell high. Why do investors sometimes do the opposite?
1. Confirmation Bias
When we start researching potential investments, we’ve often already made our mind up about whether it’s ‘good’ or ‘bad’. Confirmation bias means we then naturally start to seek information that supports our existing conclusion, dismissing those sources that go against the beliefs we have. In a way, it’s overconfidence in the initial conclusion we made.
This investment bias can lead to us making decisions that aren’t right, even when clear evidence has shown this. It can be difficult to overcome but trying to balance information is important, weighing up on its own merits rather than the fact it affirms beliefs. Having another person, including us as your financial adviser, look at potential investments can help.
2. Information Bias
We’ve highlighted why looking at the information when investing is important above. But you can have too much of a good thing.
In our modern lives, we are bombarded with information. Whether it’s in a newspaper, online or through social media, there’s a lot of information on investing out there. It can make it difficult to see the wood through the trees. This can make it challenging to understand what is relevant and irrelevant.
This is where your financial plan can help. Having a clear set of goals and understanding why investment decisions have been made with these in mind can help you focus. Let’s say you’re investing for retirement that is 20 years away, the daily movements of the stock market is unlikely to have an impact on how you should invest.
3. Loss Aversion
Would you rather gain £1,000 or not lose £1,000? Research suggests that most people tend to strongly prefer avoiding losses than obtaining gains. This investment bias can create conflicts when it comes to making decisions.
We invest for the opportunity to generate returns, this always comes with some level of risk and there’s a chance values may fall. Loss aversion can mean you don’t take the appropriate amount of risk for your circumstances and goals because you’re actively trying to avoid losses. On the flip side, some investors may resist selling assets that are down, even though it’s appropriate for them, due to the hope that they’ll make the money back.
Here it’s important to look at your investment portfolio as a whole and why it’s been built in the way it has; to help you achieve long-term goals.
4. Anchoring Bias
Anchoring bias is a tendency to place too much importance on a particular past reference or piece of information when making a decision. When looking at this from an investment perspective, the most common thing to focus on is a share price. For example, investors may hold on to investments that have lost value because they’ve anchored the value of the asset to a previous stock price. Anchoring bias can skew your perception of what investments are performing well for you.
Looking at the bigger picture and gathering information is important here, it can help create context around why an asset should be held or sold. Again, this should be done with your wider financial plan in mind to help ensure your goals stay on track.
5. Bandwagon
We’ve all heard of jumping on the bandwagon, and it happens in investing too. If you’ve felt more comfortable in decisions because many other people have made the same choice, you may be affected by groupthink investment bias. It’s easy to see why it affects bias, after all, if everyone else is doing it, it must be ‘right’.
However, what you are investing for and your overall circumstances play a key role in building a suitable investment portfolio. You might speak to ten people who are all investing in a certain industry. But without knowing what their goals are and the context of their financial situation, it’s impossible to assess if following their lead would be right for you.
How to avoid behavioural bias
We all have biases, but we don't need to act on them. By understanding what your biases are, you can learn how to avoid them when making investment decisions. By follow a robust long-term strategy is more likely instead of your unconscious whims, you're more likely to achieve your financial goals.
Look at the bigger picture: The value of investments may have fallen sharply in the last few weeks. But when you look back over the entire investment period, you’ve likely experienced gains overall. No one likes investment values falling but looking at the bigger picture can put them into perspective. If you’ve invested recently, the falls can seem more severe, but you should still have time to benefit from future rises and recovery.
Manage how often you’re reviewing investments: It can be tempting to look at investment performance frequently, especially during a period of volatility. But taking a step back and reviewing less often can help you focus on the long term.
Keep your long-term goals in mind: When you first invested it should have been with a long-term goal in mind. The reason we don’t invest for short periods is to hopefully smooth out the short-term volatility investments experience. Focus on these goals, which may still be years away.
Don’t make a rash decision when it comes to investments. If you are worried or have concerns, please speak to us. We’re here to provide confidence, including during downturns.
This article was prepared by Chris Green, our Head of Financial Planning. We always appreciate your feedback. If you have enjoyed this article or have any specific topics you would like to see addressed in future newsletters, please email us at FPTeam@city-asset.co.uk.