Is your mind playing tricks on your portfolio?

24 August 2021

8 minute read

Did you know that humans are prone to over 100 cognitive biases? And that they are capable of distorting our ability to make rational judgements and decisions?

The challenge of thinking clearly, especially when emotions might be pulling the mind in different directions, is one that investors need to rise to if they’re to avoid biased decision-making which can drag on investment performance.

Mind the generational gap

While the huge range of cognitive biases might seem staggering, there’s an additional nuance which is that these biases will be exhibited to varying degrees in different people. As an example, investors from different generations may exhibit different traits – a vital factor when discussing intergenerational investing and passing on wealth.

For this reason, Alexander Joshi, our Behavioural Finance Specialist at Barclays Private Bank, says we need to consider the stage of life as one of the factors influencing an investor’s decision-making: “Older clients may be more risk-averse due to the length of their investment horizon remaining. They want to pass the wealth onto their children, so may be more vulnerable to a bias such as Loss Aversion.

“In contrast, younger people are at the start of their journey, so may not be as concerned by market volatility in the short term, but they may exhibit other biases like overconfidence. This could lead to over-trading and being too active with their portfolio. So there can be a clash in how they view investing family wealth.”

The fear of loss

In our opinion, a key cognitive bias worth focussing on for any investor is “Loss Aversion”.

As Alexander explains, “The theory says that losses affect us more than equally-sized gains. For example, losing a £20 note on the floor affects us more than finding a £20 note. It's roughly double the impact. This is important for understanding how investors behave.”

When seeing or experiencing losses our attitude to market movements is distorted, and the focus can become stemming potential losses, which can lead investors to lose sight of the long term. Falling asset values can draw investors into a “loss frame”, causing us to perceive information and act differently versus a “gain frame”. This can be compounded by uncertainty over where the bottom is.

Rationalism to the rescue?

An academic widely regarded as one of the founding fathers of the study of behavioural economics is Nobel-prize winner, Daniel Kahneman. In his book, Thinking Fast and Slow, Kahneman proposed a principle for minimising biases: it involves switching from instinctive, immediate, and emotional thinking (“fast thinking”), to unhurried, self-questioning, and rational analysis (“slow thinking”).

Alexander agrees with this approach, and he helps clients think about their attitudes during times of volatility by posing questions. In his words, “We can keep a longer-term perspective during volatile periods, by asking clients who may be nervous about staying invested, 'Are you truly low on financial liquidity, or is it depleting emotional liquidity? What is your reference point for the current price – why is it a recent/all-time peak? If you weren’t holding the asset, would you buy or short it?'”

These questions tease out the logic behind decisions and can help bring investors back from “fast” thinking based on instinct, to “slow” rational processes.

A dastardly duo to be aware of

Two more cognitive vulnerabilities which we believe investors should be mindful of, are “Availability Heuristic”, and “Confirmation Bias”.

The first (“Availability Heuristic”) is when we assign more weight to information we can more easily recall. There is a risk that investors place lower importance on historical data, and more weight than warranted to periods of elevated volatility due to emotive and attention-seeking news headlines.

The second (“Confirmation Bias”) is a natural tendency to seek out, interpret, favour, and recall information in a way that confirms and supports one’s prior beliefs or values. During periods where market sentiment is extreme (e.g. extremely bullish), the confirmation bias can exacerbate this in investors.

Naturally, since there are so many biases, it is hard to address them all. And even neutralising the main ones is extremely difficult. “Is it really possible to rid oneself of biases?” reflects Alexander. “I think it's very difficult to rid ourselves of them due to the way our brains are wired. We can be aware of them. We can seek to recognise and plan around them when putting an investment plan together.”

A four-point plan for better decision-making

In his role, Alexander offers clients a variety of strategies to promote clear thinking. Here he shares a simple and effective four-point plan for better decision-making, particularly during market turbulence.

1. What are your goals?

Clarify your objectives and agree with or communicate them to your trusted advisers, with a pact to challenge you. This can make it easier to align investment decisions and ensure you do not go off-course accidentally.

2. Have a plan

Writing down a specific plan to get to your goals can help to achieve them. A plan with rationales, timelines, and rules for actions to be taken in different scenarios, is even more valuable. It can also keep you anchored during difficult market conditions.

3. Prepare for the unexpected

Unexpected events don’t make the world more uncertain. They simply show us how uncertain it already was. Preparation for this uncertainty involves following a robust investment process to create a diversified portfolio of quality assets, built to perform in different conditions, for the long term.

4. Recognise your biases and emotions

Periodically reviewing past decisions is one step towards improving them. Building a process that is systematic and built around identified biases can help to reduce their impact. Anywhere your skill, knowledge, or time limit your ability to follow that process, then delegating to experts with robust processes and track records may be advisable.

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