Investing – Exposing the myths
Interested in Behavioural Finance? You’ve come to the right place.
Chances are that if you are reading this, you have at least a basic interest in understanding how your emotions can have a dramatic impact on the way you make investment decisions.
That’s great – me too!
I am Peter Brooks, head of the Behavioural Finance team and I’ll be posting regularly going forward.
In my first post, I focus on demystifying all of the jargon you can come across when reading about investing and in particular, making investment decisions.
Un-confusing the confusing
With all its jargon, big numbers and reputation for uncertainty, investing can often seem like a bit of a mysterious art form.
Below are the five most common myths we hear when it comes to investment decisions – and the truth to help you avoid falling prey to them.
Myth 1: People make rational decisions when investing
Conventional finance theories still argue that individuals act rationally and consider all available information in their investment decisions. Unfortunately, in reality, this theory does not stand the test of investing. In fact, studies have found that people tend to make investment decisions without considering all implications. This is a trap that psychologists call ‘narrow framing’. We tend to focus on investment decisions one by one, without considering the impact on our overall portfolio. This means we miss out on diversification opportunities, make new investments that cancel out existing investments, or decline opportunities that look too risky on their own but would be a good addition to the overall portfolio. To avoid narrow framing always try to consider the bigger picture.
Myth 2: It’s better to take risks when you are comfortable
We tend to take more risks when we’re comfortable, and fewer when we’re not. We’re comfortable when markets have been rising for a while and we’ve been surrounded by good news and uncomfortable when we’ve been through times of stress and chaos. Unfortunately, this means we all have a strong tendency to take on a little bit more risk when markets are high, and less when they’re low: we buy high and sell low… you don’t need to know much about investing to realise that is the opposite of the best investment strategy.
Myth 3: It’s good to invest in areas that are familiar
Only invest in things you know would tend to be a good investment mantra. However, there is a difference between doing your homework and falling foul of the familiarity bias. Investments, whether in countries or companies, tend to feel less risky if they feel familiar. We often confuse familiarity with understanding. This can be really useful if you are investing for the first time and have a plan to diversify more as you build your investment portfolio. However, in the longer term, familiarity bias can lead to overconcentration in single countries or companies, and although your perception of risk may be low, the reality could be quite the opposite. Do your research to understand what you are investing in and wherever possible diversify your portfolio.
Myth 4: At times of volatility, it’s good to move your investments around to minimise risk
In volatile markets, in particular, we have a strong bias towards wanting to do (or be seen to be doing) something about this turbulence – it makes us feel better. This is called the ‘action bias’. If your portfolio is reasonably well structured to start with, however, then simply doing nothing would often be a much better option. The more you trade, the higher your costs, and the higher the chance of trading emotionally or based on pure noise or inaccurate information. Most of the time the best advice is simply to do less than you’re inclined to.
Myth 5: Investments should be compartmentalised from all other aspects of your finances
All of us are guilty of the tendency to mentally break our finances into categories (known as mental accounts) and treat each differently: essentials, holiday money, savings, inheritance, etc. This can simplify decision making and help us to keep track of everything, but also leads to inefficiencies because we fail to notice that if we transferred money
And this brings my first post to its end.
I hope I have been able to un-confuse the confusing but if you have any questions or comments, I would love to hear from you.