How to recognise and overcome your biases

FNB INVESTMENTS

IN LAST month’s article we touched on having the right mindset and being aware of how our minds and emotions work when it comes to making investment decisions.

This article delves a bit further into the particular biases that we all have to a certain degree.  The aim is to understand how our cognitive and emotional biases can potentially impact our investments.

 

Cognitive bias

This bias involves using mental short cuts or ‘rules of thumb’ to make decisions.  The problem is that these may or may not be accurate.  We highlight some examples below:

  • Confirmation bias involves giving more weight to those opinions that agree with yours. Investors tend to look for reasons to back up their investment opinion, as opposed to finding facts that might not support the idea.  This may lead to an investment idea looking better than it is.
  • Gambler’s fallacy is trying to predict market movements based purely on past movements—for example, deciding that because a stock has done well, “it has gone up too much” without looking at whether the underlying fundamentals may justify such a market reaction.
  • Status quo bias is where investors become comfortable with sticking to the familiar, and not deviating from previous investment decisions.Sticking to your strategy is usually a good thing—but when conditions change, you need to be willing to adapt in order to invest successfully.
  • Risk-aversion bias causes investors to place more emphasis on bad news, as opposed to good news, meaning investors can miss out on good investments because they believe that conditions will remain poor, or will deteriorate over time. This results in investors turning to risk-averse assets with low-risk profiles—especially during times of volatility.
  • Herding, or ‘fear of missing out’, is the tendency of investors to follow what others are doing, as opposed to doing their own research. An example of this was when Bitcoin reached $19 000 a coin—many investors did not know what they were investing in, however, they still acquired coins as everyone else was doing it.

Emotional bias

Making emotional decisions is not always bad, as individuals can use emotions to make a more protective decision at the right time.  However, these decisions are not scientific, and therefore the success thereof will differ from decision to decision and investor to investor.  We highlight some examples below:

  • Loss-aversion bias: Investors often leave a non-performing stock in their portfolio to avoid ‘banking’ or ‘locking in’ a large loss with the hope that the price will move back up again in the future. There is an opportunity cost associated with this, however, and selling the stock could free up capital to invest in a stock or asset with higher return potential.
  • Endowment bias goes together with loss-aversion bias, and is where investors feel that what they currently own is more valuable than what they do not. This could result in remaining invested in a certain stock while other shares or assets may have better prospects for growth.
  • Overconfidence bias: Perhaps owing to past success, an investor may have too high a regard for their own in-vestment abilities. This could lead to higher-than-appropriate risk bets being taken—either in size, or in the investment choice being made.
  • Self-control bias results in investors deviating from their savings and investment plans, often through making erratic buying and selling decisions without considering the fundamentals of the investment.
  • Regret aversion is where investors avoid making a decision that will result in action, out of fear that the decision being made will turn out poorly.

Conquering investment biases

Knowing that these biases exist—and that you more than likely exhibit some of them—is the first step in righting the mistakes we make and avoiding similar wrong turns in future.  Other strategies through which you can conquer your own bias include:

  • Determining your investment goals and individual risk profile is the first step in making investment decisions that are suitable to you.
  • Adopting a scientifically tried and tested investment strategy and being ruthless in your application of that strategy may help you avoid some of the mistakes made by most investors.
  • Doing your research can help you avoid making mistakes due to basing decisions on intuition and feeling rather than cold hard facts.
  • Investing in unit trust funds or exchange-traded funds takes the investment decision-making process out of your hands.
  • Finding a partner who is as invested in your financial plan and outcomes as you are can provide a valuable outside perspective that could help you avoid making biased decisions by reminding you of your goals, risk profile, and strategy—or by providing you with the information required to make more informed decisions.