Four behavioural biases for investors to be aware of

Please note: The article does not constitute advice or any form of investment recommendation.

The cycle of market emotions

Broadly speaking, investors behave in fairly systematic ways, experiencing predictable emotions over an investment cycle, that can derail objectives if left unchecked.

Cognitive biases – systematic deviations from rational behaviour – are exacerbated when emotions run high. This can lead to buying near market highs when investing feels emotionally comfortable, and selling near market lows when staying invested feels uncomfortable. Both these short-term reactions can potentially damage your longer-term performance objectives.

Understanding ourselves better, pays dividends

Being aware of your behavioural tendencies, and preparing for them from the outset, can help you to make better investment calls and improve your chances of success. As with many other things in life, if you can better understand the possible risk-reward ratio of your immediate actions, then it can be beneficial for your longer-term interests.

Regular readers of our thought leadership articles will be familiar with the importance that we place on understanding and overcoming ‘loss aversion’ as the key bias for all investors. In this article, we examine four additional behavioural biases.

(As a reminder: losses, psychologically, tend to have a far larger impact on us than equally-sized gains, and viewing markets and portfolios through a ‘loss frame’ affects the way information is perceived, decisions are taken, and crucially, our willingness to react to risk in an attempt to stem those losses).

1. Confirmation bias

Confirmation bias is a human tendency to seek out, interpret, favour, and recall information in a way that confirms one’s prior beliefs or values.

As an example, an investor with a particularly bullish view about market conditions might overweight positive news around US jobs and inflation, while paying less attention to the downside risks. This bias can lead investors to holding portfolios that are less diverse and so offer less protection should unexpected scenarios play out (think the sell-off in equities caused by the outbreak of COVID-19 in 2020).

It is good practice when consuming financial news to pay attention to, and actively seek out, views which are different from your own, so as to minimise the likelihood and impact of nasty surprises.

It also pays to apply a critical eye to market narratives. Narratives are powerful because they can feel right, especially if there is some evidence to support them. Whether the causal relationship the narrative seeks to explain is strong can become immaterial; what matters is that the story is convincing. Once the link has been forged, it can be hard to break into an investor’s mind. Additionally, the simpler the narrative, the easier it can be understood, shared, and become the prevailing explanation, even if key variables are missed from the explanation.

2. Hindsight bias

Hindsight bias is the tendency to overstate one’s ability to have foreseen an event’s outcome. Once we know the result – of say a sporting event or an election – it becomes easier to construct a plausible explanation in our minds. We selectively remember the information we knew that supported the outcome and believe that we knew what the outcome would be all along. The overconfidence that stems from this can lead to becoming less critical of future decisions.

When investing, hindsight bias can cause investors to regret not positioning their portfolio appropriately for an event. We remind all investors of the difficultly of timing the market. As the adage goes, it’s not about timing the market, it’s about time in the market.

3. Anchoring effect

Our past experiences can influence and bias our expectations. The anchoring effect is when an individual's decisions are affected by a specific reference point or 'anchor'. In particular, we can assign too much weight to the first piece of information we receive on a subject.

In investing, there can be a tendency to use a recent market high as an anchor level – for example, ‘My portfolio is down x% from the high’. In real estate, the initial purchase price can be used to justify the price a seller will accept, even when market conditions have changed since the purchase.

A way to overcome the anchoring effect is to keep focused on one’s long-term goals and how to maximise the chances of achieving them. It’s valuable to recognise that past market highs will essentially be arbitrary dates over the course of an investment journey.

4. Mental accounting

Mental accounting is the concept whereby people treat money differently depending on factors such as its origin and intended use, rather than thinking about the “bottom line”, as in accounting. For example, money intended for our children’s education and money intended for retirement.

Bucketing wealth for different uses can be helpful for budgeting and wealth planning purposes, especially if you have multiple goals for your wealth and a complex web of finances.

However, this can lead to a suboptimal use of funds, in particular if too much is held in cash. This is especially true at the moment, and during other periods when inflation is high, as the value of cash can be significantly eroded.

Money is fungible - it is interchangeable and has no labels – but in mental accounting, people treat assets as less fungible than they really are. It is important to keep a holistic picture of one’s entire wealth to ensure it is being used as productively as possible.

Plan around your biases

We are all prone to different biases, to varying degrees. Being aware of your own ones, and building processes around these, can help you to overcome them. Delegating to experts who follow robust processes and can challenge your thinking, may be one effective way of doing so. 

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