How to stop behavioural biases affecting your investment decisions
By Alan Boswell Group
Knowing where and if you should invest can be challenging, even more so now we can access news and opinions from all around the world. But while this wealth of information can give us more options, it can be overwhelming, lead to sub-optimal decisions, which in turn, can result in poor investment outcomes.
To help avoid this, we explore the idea of behavioural biases, how they can influence your choices and what you can do to prevent them from affecting financial decisions.
What is behavioural bias?
Behavioural bias describes beliefs, assumptions, and attitudes we hold without really knowing why. In other words, ‘going with your gut feeling’. These beliefs are often so deep-rooted that we don’t even know when they influence everyday decisions. They’re essentially mental shortcuts that enable us to make quick decisions – for example, if red is your favourite colour, it might mean you walk through a red door rather than a green door.
In reality, these behavioural biases result from our own lived experiences. Biases can also be formed by the unconscious beliefs of our family and friends, particularly as we’re growing up.
Ultimately, behavioural biases are driven by emotion and can lead to both good and bad outcomes.
What are behavioural biases in investment decision making?
The principle of behavioural bias in investing is the same. It’s how your unconscious beliefs shape financial decisions instead of basing those decisions on research, data, and facts.
You may not feel as if your decisions are affected by behavioural bias but therein lies the trap, as bias is something that most of us simply aren’t aware of.
What are the five biases people have when investing?
Behavioural bias is broad and describes a whole spectrum of actions, but typical biases that affect investment decisions include:
Herd mentality
This is when decisions are made based on what everyone else seems to be doing.
Herd mentality can be good if the action is based on facts, but it can also lead to a false sense of security. After all, if the majority of other investors are doing it, shouldn’t you be?
Fear of missing out can lead to hasty decisions, which can result in poor outcomes. For example, panic selling in an economic downturn or buying overvalued assets.
Availability bias
Availability bias is about information retrieval. Specifically, it describes how we tend to better remember recently acquired news or how some stories stick in our minds (in other words, this news is readily available).
However, the information we recall immediately might be sensationalist or unusual (hence why we remember it). More often than not, availability bias can lead to knee-jerk reactions based on rare or unique events.
For example, the news might be filled with stories about political tension that causes the price of gold to drop. As the news becomes more widespread (or sensationalist), you may decide to sell any gold assets you have despite being considered relatively secure compared to other investments.
In the short term, that decision might seem good, but after the headlines stop, it might prove to have been hasty.
Confirmation bias
This is where we focus on or actively try to find information that supports our opinions (albeit unconsciously). Any negative or conflicting information found is ignored, so that the positive stories are amplified.
An example would be if you wanted to invest in a company whose ESG values align with your own. Your enthusiasm could lead you to downplay emerging stories about poor leadership or overly aspirational targets. As a result, it could mean you end up buying shares in an overvalued company, potentially leading to significant losses.
Endowment effect
The endowment effect is also known as ownership bias. It’s when we place greater value or importance on the things we already own. For example, if you decide to sell your car, you might base its sale price on the fact you think it’s a desirable vehicle. In reality, your car may not hold the value you think it does, and it’s only worth what people are willing to pay for it (or what the market dictates).
The endowment effect could mean you keep hold of poor value assets longer than necessary rather than letting them go at the right opportunity.
Loss aversion
This simply describes our dislike of losing.
Loss aversion works alongside many of the other behavioural biases. For instance, the desire not to lose out on a potentially money-making investment might drive you towards making a decision based on herd mentality.
It’s also closely linked to the endowment effect – keeping assets that should be sold, because we don’t want to sell them at a loss.
Do behavioural biases affect financial advisers?
Behavioural biases affect all of us. However, the key difference is that financial advisers will be aware of how bias can affect decisions and will act objectively, without emotion, to help you reach your goals.
How can investors avoid behavioural biases?
If you’re planning to manage your own investments, there are several practical steps you can take to avoid behavioural biases, including:
Carefully consider what you read – try to view headlines and stories objectively. If something is portrayed in a certain way, checking its source can help you determine its intention.
Be mindful of the herd – don’t rely on others for your information without doing your own research.
Remember your objectives – it’s easy to be swayed by quick wins but don’t forget what you want to achieve. Keeping your intentions in mind can help prevent you from making rash decisions.
Diversify your portfolio – this means investing in several different assets in a range of sectors or industries. Spreading the risk can help minimise overall losses. Portfolio diversification can also provide surprises that can help challenge any biases you may have.
Of course, if you’re not sure you can remain objective when making investment decisions, delegating the management of your investments to an independent financial adviser, such as Alan Boswell Group, can mitigate the risk of making an expensive mistake, taking the pressure away from you. A holistic, personalised approach to investment management ensures that your investments are aligned with your goals and tie-in to any other important financial decisions, such as retirement planning.
Independent investment advice from Alan Boswell Group
Our wealth management service can help you make the most of your existing assets to secure your financial future.
As we’re independent, we’re not restricted to only recommend certain products. It also means we can take a flexible approach and offer solutions aligning with your goals.
Plus, as we believe in a one-to-one service, you’ll be assigned your own personal wealth manager.
To learn more about our financial planning services, including advice on savings and investments, contact our team.
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Please note, the value of investments and any income from them can go down as well as up and you might not get back the original amount invested. The past is not a guide to the future.