Four behavioural biases for investors to be aware of
By Alexander Joshi, Barclays Private Bank
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.
This communication is general in nature and provided for information/educational purposes only. It does not take into account any specific investment objectives, the financial situation or particular needs of any particular person. It not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful for them to access.
This communication has been prepared by Barclays Private Bank (Barclays) and references to Barclays includes any entity within the Barclays group of companies.
- is not research nor a product of the Barclays Research department. Any views expressed in these materials may differ from those of the Barclays Research department. All opinions and estimates are given as of the date of the materials and are subject to change. Barclays is not obliged to inform recipients of these materials of any change to such opinions or estimates;
- is not an offer, an invitation or a recommendation to enter into any product or service and does not constitute a solicitation to buy or sell securities, investment advice or a personal recommendation;
- is confidential and no part may be reproduced, distributed or transmitted without the prior written permission of Barclays; and
- has not been reviewed or approved by any regulatory authority.
Any past or simulated past performance including back-testing, modelling or scenario analysis, or future projections contained in this communication is no indication as to future performance. No representation is made as to the accuracy of the assumptions made in this communication, or completeness of, any modelling, scenario analysis or back-testing. The value of any investment may also fluctuate as a result of market changes.
Where information in this communication has been obtained from third party sources, we believe those sources to be reliable but we do not guarantee the information’s accuracy and you should note that it may be incomplete or condensed.
Neither Barclays nor any of its directors, officers, employees, representatives or agents, accepts any liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this communication or its contents or reliance on the information contained herein, except to the extent this would be prohibited by law or regulation.