6 Behavioural Biases That Can Impact Your Investment Decisions

What Are Cognitive Biases?

Cognitive biases refer to types of errors that can occur during the thinking process i.e. when we are processing and interpreting information. In order for us to make sense of the situation or matter at hand and to reach a decision quickly, our mind turns to mental shortcuts.

It can be overwhelming if we have to consider every possible option and outcome when making a decision. Because of the information overload, it is necessary to rely on mental shortcuts that allow us to act swiftly. This is true with many investors. They tend to depend on cognitive biases more than they should to make important decisions, like when to buy and sell an investment.

Confirmation bias is one of such cognitive biases. This is where there is a tendency to ignore information that challenges or contradicts our views and opinions. The behaviour from this bias is displayed repeatedly in the investment world.

Anchoring bias is another cognitive bias. This is where we continue to use information we have used to make decisions in the past despite the availability of new and relevant data.

What Are Emotional Biases?

Emotional biases typically occur spontaneously based on the personal feelings or emotions of an individual at the time a decision is made. They may even be deeply rooted in personal experiences that also influence decision-making.

Emotional biases are usually psychological and can generally be harder to overcome than cognitive biases. In some cases, an investor’s emotional bias may help them to form a more protective and suitable decision for themselves. Emotional biases have to do more with our fears and/or desires, rather than our reasoning.

Like cognitive biases, investors are prone to use emotional biases to make important investment decisions.

The loss aversion bias refers to our tendency to feel the pain of loss more profoundly than the joy of an equivalent gain, can lead investors to hold on to losing assets longer than they should to avoid the pain of seeing a loss materialized. This bias only exacerbates losses even more.

The status quo bias prevents investors from making changes that may be beneficial. For example, investors who don’t make adjustments to their retirement savings allocations over time could end up with a portfolio that is riskier than it should be, given their proximity to retirement.

Overcoming Our Biases

Recognizing that we ‘naturally switch on’ biases to make decisions is the first step to overcoming them. While it is nearly impossible to be unbiased in investment decision-making, investors can, we can, however, mitigate biases by understanding and identifying such prejudices. They can do this by creating trading and investing rules i.e. a framework that can help to reduce the impact of biases to achieve better outcomes.

Here are 6 common cognitive and emotional biases that can derail investors’ long-term objectives:

Cognitive Biases

1. Confirmation Bias

People tend to seek and pay attention to evidence that confirms their existing beliefs, ignoring other information that challenges or contradicts their views. This happens as people tend to avoid what is called “cognitive dissonance” – the mental discomfort that happens when new information conflicts with our beliefs or perceptions.

What are the effects on investors?

In the investment world, confirmation bias is a frequent occurrence. When investors ignore negative information, they miss out on the warning signs that can help them to avoid or reduce losses. On the other hand, when investors ignore information that supports differing points of view, they miss out on attractive opportunities.

2. Anchoring Bias

Anchoring is the tendency to rely too heavily on the first piece of information we get hold of and this can have a huge impact on the decisions we make. It is the tendency to use first impressions to form further perceptions. Once this first piece of information is ‘anchored’ in our mind, our brain makes judgments by adjusting away from that anchor. This in turn creates a bias towards interpreting other information around the anchor.

What are the effects on investors?

I have come across investors who have held on to investments that have lost value for much longer than they should. Why do they do that? This is because they have anchored the fair value estimate of the investments to the acquisition price instead of the underlying fundamentals. What may not be apparent to these investors is that they are in fact taking a greater risk by hanging on to the hope that the security will return to its initial price.

3. Narrative Bias

Our ability to evaluate information objectively is hindered by what is called the narrative bias. We love stories. Why? Stories typically have emotional elements that appeal to our subconscious thoughts. And because stories have that emotional angle, they are easy to remember.

When there is narrative bias, it means that we have let our preference for a good story overrule the facts and therefore, affect our ability to make rational decisions. In other words, this can cause us to lean towards a less desirable outcome simply because it has a better narrative.

What are the effects on investors?

Similarly, investors tend to abandon evidence in favour of a specific stock or strategy that can be understood through a memorable story. But it should never come to a point where investors prioritise the narrative over data.

It is important to ask yourself this: “Have I analysed data and information objectively that could help justify or disprove my position about this investment?”

Emotional Biases

1. Overconfidence Bias

Overconfidence bias is the tendency for a person to overestimate his or her own abilities. This false and misleading assessment of our intellect, skills, talent can be dangerous, especially in investing.

Being overconfident can make one prone to making mistakes in investing. It often leads people to overestimate their understanding of financial markets or specific investments and disregard data and expert advice.

People showing overconfidence can also mistakenly equate information quantity with quality. They tend to feel more confident after going through substantial amount of information, even though it could be of poor quality. This can lead to risky investment decisions.

What are the effects on investors?

In investing, overconfidence bias often leads people to overestimate their understanding of financial markets or specific investments and ignore facts and advice from experts.

It is a common phenomenon to see this in overconfident people – they tend to underestimate the risks or overestimate the expected returns of an investment. They tend to time the market or focus only on risky investments. Trading excessively is something such investors do day-in and day-out. They are quick to sell an asset that has disappointed them, only to buy a brand new security that they feel more than confident about.

2. Status Quo Biases

As the term suggests, the status quo bias describes our preference for the current state of affairs, resulting in resistance to change.

Why do we tend to leave things as they are? I am sure you would agree that people are generally more comfortable with the familiar than spending time and effort to make adaptations. This bias might prevent an investor from checking out opportunities where change may be beneficial.

What are the effects on investors?

Investors unwilling to change or adapt to new information may end up with portfolios that are no longer suited to their current circumstances.

3. Endowment Effect

The endowment effect describes a circumstance where an individual places a higher value on an object that they already own than the worth they might assign on that same object if they didn’t own it.

When investors are subject to the endowment effect, they give the holdings that they own a disproportionate value simply because they already own them.

What are the effects on investors?

Investors may hold on to losing or unsuitable assets even when they do not fit with their risk tolerance or investment goals any more. This focus could adversely impact a portfolio’s diversification and even makes investors miss out on other better opportunities.

In Summary

Awareness of the behavioural biases is the first step to solving the problem. Investors can avoid these behavioural biases by delegating investment decisions to a Certified Financial Planner or an investment manager.

Do ensure that the professional guiding you has a clear and disciplined investment process, a diversified portfolio approach, and high ethical standards.