5 common behavioural biases you need to be aware of when investing
Choosing what to have for dinner when out with friends or what you’re going to do at the weekend will be influenced by your emotions, whether you realise it or not.
The same can be said for your financial decisions. In fact, anger and frustration are just two emotions that can very easily affect how you perceive investment opportunities. While this is understandable, emotional decision-making can lead you to make snap decisions, often costing you potential returns.
Indeed, FTAdviser reports that advisers believe emotion-led decisions cost their clients at least 2% each year in foregone returns.
So, read on to discover five behavioural biases that you need to be aware of when investing and how working alongside a financial planner can help you reduce the influence these biases can have on your investment decisions.
1. Herd mentality
When markets are facing uncertainty or are seeing volatility, some investors can seek to “follow the herd”.
Also known as the “herd instinct”, investors will join groups and follow the actions of others, often because they assume that the other individuals have already done their research.
In fact, some investment companies now encourage doing exactly that, offering you software that will automatically invest in popular equities for you.
One of the biggest examples of following the herd was the GameStop episode in January 2021. Users on a Reddit thread initiated a short squeeze on GameStop, which led to a 600% rise in its stock value over the following few days.
On January 28, the GameStop share price had risen to $483, compared to $19 just a few days before. With the stock price rising so rapidly and news coverage occurring every day, there became a rush to buy shares and a huge demand among investors keen to make a quick return.
However, when the share price inevitably fell, many people who followed the crowd – especially those who invested later – lost out.
2. Loss aversion
For many investors, avoiding loss is preferable to achieving gains. This form of behavioural bias is known as “loss aversion”.
Originally coined in 1979, by Daniel Kahneman and Amos Tversky, loss aversion refers to the theory that losses could be psychologically twice as powerful as gains.
So, if you have a bias towards loss aversion when you are investing, you might not give any gains much thought and simply move on to the next investment. However, if you were to make a loss, you would be more likely to take it more personally as a serious failure of judgement and let it influence any future investment decisions you make.
Attempting to avoid loss might mean you don’t take enough risk and, consequently, don’t achieve the growth you need to achieve your future objectives. This is when working with a financial planner could make a significant difference in your thinking.
3. Hindsight bias
Hindsight bias can cloud your objectivity in assessing past investment decisions and limit your ability to learn from past mistakes.
This type of behavioural bias refers to a tendency to see bad past events as unpredictable and beneficial events as predictable. Sometimes, investors will blame poor investment performance on the volatility and unpredictability of the markets, whether this is true or not.
In fact, it’s likely that most investment mistakes can be attributed to errors of judgement rather than market volatility or unpredictable events.
To reduce hindsight bias, it could be worth speaking to a financial planner, and setting out your investment plans, including the reasons for the potential investment and any estimated returns.
4. Overconfidence
In daily life, overconfidence can occur at any time, whether its UK adults thinking they are better than average drivers or someone claiming to be highly skilled at a particular sport.
This level of overconfidence can occur in investing, too. For instance, if an investor has previous success, they can become overconfident and believe that they know everything there is to know about investments. This can lead to them basing any future decisions on their recent “win”.
This is often the case when investors aren’t receiving advice or support from an experienced financial planner.
A common human behaviour is to protect egos, and this is no different when it comes to investing. In fact, those investors being influenced by their overconfidence bias are more likely to get a false impression of success and avoid seeking any guidance or advice from professionals.
So, whether you have had success with previous investments, or it is your first time investing, speaking with a financial planner could be more beneficial to you than going it alone.
5. Confirmation bias
People’s tendency to process information by interpreting, or looking for, information that is consistent with their existing beliefs is known as “confirmation bias”.
When investing, this can often lead to you processing information that supports your own beliefs and then basing your investment decisions on this. Similarly, while you might be drawn to information that confirms your beliefs, you are also just as likely to ignore any evidence that goes against them.
While this biased approach is generally unintentional, it can have a profound effect on any investing strategy.
Get in touch
If you are considering investing your wealth, speaking with an experienced financial planner could be beneficial. At HarperLees, we will act as a sounding board to help you avoid making emotion-led financial decisions and keep you on target to meet your long-term objectives.
Please email info@harperlees.co.uk or call 01277 350560.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Investments carry risk. The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
