It’s not unusual for investors to sense a tug-of-war between their analytical brains and their emotions. Until fairly recently, investing was considered purely logical. Find the right quantitative strategy or forecasting model, and you’d be off and running. We now know that investing, and the decisions leading to many of the mistakes investors make in financial markets, are not caused by their ignorance of financial instruments but by their behaviour.
These mistakes are influenced by emotions and are often involuntary and unintentional. This connection between financial markets and psychology is very important and there is a specific field of study devoted to it: behavioural finance.
Behavioural finance has increasingly become part of mainstream finance, providing explanations for people’s economic decisions by combining behavioural psychological theory and conventional finance. Behavioural finance studies the effects of emotional factors on the economic decisions of individuals and the consequences they have for financial markets.
Behavioural finance is a field of study that offers explanations for these irrational individuals’ investment decisions as well as financial market outcomes. Understanding our cognitive biases can lead to better decision making, which is fundamental, in our view, to lowering risk and improving investment returns over time.
We have outlined below, 3 key cognitive biases that can lead to poor investment decisions. The below list is by no means extensive and there are worse ways to spend your time as an investor then by researching and attempting to master these cognitive biases.
There’s nothing wrong with a little self-confidence. There is, however, something wrong if it distorts our reality. That’s what happens with overconfidence bias: We tend to overestimate our own abilities, thinking we know more than we actually do. You see this trait often in people who believe they have some sort of unique secret strategy for outsmarting the market. As humans, we’re pretty bad at judging our own abilities.
People who are prone to overconfidence should also do a gut check on their risk tolerance because they may find that they’re more scared of the possibility of failure than they realise. Generally, the person who’s overconfident only sees a positive outcome, so we ask our clients to do an exercise and assume that the investment doesn’t work out and they lose it all. What do they see as the impact on their life, on their relationships?
And there’s one more thing to consider: A well-known study in the Journal of Finance says that overconfident investors also tend to trade more frequently—and every trade means you’re paying more fees that could eat into your returns.
Confirmation bias is the natural human tendency to seek or emphasise information that confirms an existing conclusion or hypothesis. In our view, confirmation bias is a major reason for investment mistakes as investors are often overconfident because they keep getting data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong, which increases the risk of being blindsided when something does go wrong.
To minimise the risk of confirmation bias, we attempt to challenge the status quo and seek information that causes us to question our investment thesis. In fact, we are always seeking to ‘invert’ the investment case to analyse why we might be wrong. We continually revisit our investment case and challenge our assumptions. It is much more important to ask yourself why you are wrong than why you are right. Charlie Munger, the Vice Chairman of Berkshire Hathaway and Warren Buffett’s business partner, said: “Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”
Loss Aversion Bias
The human tendency to take extreme measures to avoid loss leads to some behaviours that can inhibit investing success. Financial advisers & investment managers will normally ask you to complete a questionnaire to establish your attitude to risk. Your tolerance to risk tends to drive the types of investments they recommend for you. However, the human attitude to risk and reward can be very complex and subtle. It can also change over time and in different circumstances.
Behavioural finance suggests investors are more sensitive to loss than to risk and potential return. This means that investors sometimes hold on to losing investments hoping they will recover their losses while quickly selling winners to realise a gain. As a result, investors’ ‘risk profile’ changed depending on whether they are facing a loss or a profit.
Investors should stay focused on their long-term planning goals whilst continually developing self-awareness of the emotions that drive their behaviour.
Additionally, they should maintain an adequate liquid cash reserve for living expenses. Knowing that you don’t have to react to today’s market headline to meet your everyday needs will help keep your emotions in check and increase the probability of a successful, long-term investment outcome.
If you can’t control your emotions and don’t have the time or necessary skill to manage your investments, consider working with an investment manager to formulate a written investment policy statement. This can prevent investors from making irrational decisions during times of economic stress or euphoria.
By understanding the common behavioural mistakes investors make, investors take the emotion out of investing by creating a tactical, strategic investment plan customized to the individual. The most important aspect of behavioural finance is peace of mind.
By having a thorough understanding of your risk appetite, the purpose of each investment in your portfolio and the implementation plan of your strategy, it allows you to feel much more confident about your investment plan and be less likely to make common behavioural mistakes driven by these cognitive biases.
Article sourced from Luthuli Capital Website