The first principle is that you must not fool yourself and you are the easiest person to fool.
Richard Feynman, Nobel prize winning physicist
Successful investing requires a mix of discipline, diversification and a long-term perspective. It sounds simple enough, but investors have a tendency of getting in their own way which can work to derail their financial plans and jeopardize their investment objectives. The greatest obstacle to successful investing may be our own psychological biases.
Psychological biases in investing are generally divided into two categories: cognitive biases which are errors in information processing and emotional biases which are errors that arise due to our unique personal feelings and instincts rather than objective data. We will explore several of the most common cognitive and emotional biases explaining what they are, how they impact us and what we can do about them. Knowing your own unique blend of investing biases can help you protect yourself against their consequences and go a long way to making you a more successful investor. Here are some of the most common cognitive and emotional biases.
Confirmation bias
What it is
Confirmation bias is a cognitive bias where we search for, interpret, favour or recall information in a way that confirm our preexisting beliefs. People exhibiting confirmation bias will selectively focus on evidence that support their views while ignoring or minimizing information that contradicts their beliefs.
How it impacts you
Investors susceptible to confirmation bias may hold on to losing investments if they disregard broad market signals or critical warning signs. Instead, they may focus on a single positive piece of news or analyst report that confirms their original investment decision. Further, investors may ignore diversification and concentrate their portfolios in a specific company, asset class or geography. This can result in exposure to risks that could be avoided in a properly diversified portfolio.
What you can do about it
There are several strategies we can consider to mitigate the consequences of confirmation bias. For example, before making an investment, an investor can play the devil’s advocate by actively searching for bearish or contrarian arguments for an investment that they are considering. Asking yourself what could go wrong with an investment can force you to think about scenarios you might not have otherwise considered.
It can also be helpful to write down your thesis for why you bought an asset. If you see negative news about a company, ask yourself if the new data invalidates your original thesis. If it does, it may be time to re-evaluate the investment.
Anchoring
What it is
Anchoring is a cognitive error where individuals rely too heavily on the first piece of information they receive which acts as an anchor when making important decisions. All subsequent information, estimates or negotiations are judged in relation to this initial reference point which can often skew rational judgment.
How it impacts you
Anchoring can result in individuals focusing on past prices and ignore current data, market conditions and fundamentals. As with confirmation bias, anchoring may cause investors to hold on to losing positions simply because they are anchored to the price they paid which is arbitrary and irrelevant to the subsequent success or failure of an investment. Conversely, anchoring can also cause individuals to sell an investment too early. By anchoring to an initial purchase price, they may sell an asset as soon as it turns a small profit thus missing out on long-term growth potential.
What you can do about it
Overcoming anchoring requires separating the emotional attachment of an asset’s history – the price you paid when you made the investment – from its current fundamentals. You can counteract the anchoring bias by implementing actionable, evidence-based strategies. For example, avoid “break-even” fixation by never letting your original purchase price dictate when you sell. An investment doesn’t know what you paid for it so base exit strategies on fundamental deterioration not on an entry price you may be anchoring to.
Another strategy is to perform a “clean slate” analysis by assessing your holding as if you just received a cash equivalent of the current market value. Asking yourself: If I did not currently own this investment, would I buy it at today’s price? If the answer is no, it might be time to sell, regardless of what you originally paid.
Loss aversion
What it is
Loss aversion is an emotional bias where people strongly prefer avoiding losses over acquiring an equivalent gain.
How it impacts you
Psychologists Daniel Kahneman and Amos Tversky originally coined the term “loss aversion.” They found that losses tend to be treated as if they were twice as large as an equivalent gain meaning that an individual subject to loss aversion would require a $200 gain to make up for the pain they would feel from losing $100. In investing, this can cause investors to lean entirely on overly conservative assets like cash and low-yielding savings accounts. While the investments may be considered low risk, they may fail to outpace inflation and thus jeopardize long-term financial goals.
What you can do about it
Loss aversion can be overcome by considering actionable steps. For example, reducing the frequency that you check your portfolio reduces the opportunities for stress during short-term fluctuations. Instead, review your investment statement quarterly or annually to remove the psychological impact of seeing a decline in your portfolio value.
Another actionable step is to diversify across multiple asset classes (equities, fixed income and alternatives) to buffer the emotional blow of volatility in any single investment or asset class.
Regret aversion
What it is
Regret aversion, related to loss aversion, is the emotional bias where people avoid making decisive financial moves due to the fear that the choice will turn out poorly.
How it impacts you
By anticipating the regret of a bad decision, investors may exhibit decision paralysis and not make any decision at all. They may fail to rebalance portfolios, avoid profit-taking or stay in cash to avoid potential market drawdowns which can ultimately hurt long-term investment returns.
What you can do about it
Like loss aversion, regret aversion can be overcome with actionable strategies. For example, automate investing with pre-authorized contributions for dollar-cost averaging to remove the pressure of timing the market and second guessing your purchase price.
Another strategy can be focus on the investment process, not short-term results. A negative short-term result doesn’t necessarily mean your decision-making was flawed. Base investment actions on evidence and data rather than emotional gut reactions.
Herd mentality
What it is
Herd mentality has both cognitive and emotional components and occurs when investors make decisions based primarily on group behaviour rather than independent analysis.
How it impacts you
It is psychologically easier to follow the crowd. Herding often manifests through the fear of missing out (FOMO) when a stock is going up in price. If your neighbour is making money on a particular stock, you might be tempted to join in, so you don’t miss the opportunity. Conversely, if an investment fails but others own it too, the sting can be minimized even thought the investment loss is not. Herding leads market participants to skip crucial steps like due diligence and fundamental analysis.
What you can do about it
Herding can be mitigated by thinking like a contrarian. Instead of automatically following the crowd, try to think about ways that the prevailing consensus could be wrong. Actively seek out unpopular perspectives and information that challenge the conventional narrative.
Another mitigation technique can be to filter out noise by limiting your exposure to financial news and social media sites during periods of sharp market volatility. Fear of missing out and panic selling are contagious in volatile environments.
Home bias
What it is
Home bias is another bias with both cognitive and emotional features. Home bias may manifest itself when investors gravitate to what is most familiar which is an emotional response. People generally prefer investing in domestic equities rather than diversifying with foreign investments. A cognitive element of home bias is the illusion of special knowledge because domestic investments are familiar to the investor and result in overestimating their ability to predict local market performance.
How it impacts you
Canada makes up roughly 3% of the world’s capital markets but many surveys conclude that Canadians allocate about 50% of their investment portfolio to the domestic market meaning that they exhibit significant home country bias and neglect foreign allocations.1
What you can do about it
Home bias can be countered by setting target allocations for your portfolio. With the help of a financial professional, determine exactly what percentage of your portfolio should be domestic versus international and stick to your target allocation range.
Another strategy can be to think in terms of global sectors. Canada, for example, is rich in resources, meaning our energy and materials sectors make up a large part of the S&P/TSX Composite Index. Conversely, our health care and technology sectors are comparatively small. Therefore, an allocation to Canada that over-weights resource sectors globally can be balanced with international investments in health care and technology.
What this means for investors
Working with a financial planner or financial advisor can help you understand your cognitive and emotional biases when it comes to investing, including what they are, how they impact you and what you can do about them.
A financial planner or financial advisor can be your “investment coach”. When volatility arises, a good coach will counsel their client to stay the course instead of acting rashly based on cognitive or emotional biases that may be exacerbated during a stressful time.
InvestEd
Warren Buffett, the legendary investor, famously said, investing is simple, but not easy. Cognitive and emotional biases in investing bear out the wisdom of this adage. Fortunately, help is available. Educating yourself about your unique blend of behavioural investing biases and seeking out the advice of a qualified financial planner or financial advisor will go a long way to ensuring you stay on track during your financial journey.
References
