The Psychology of Investing: What to do about bias

Surely investing is a logical, business exchange where people make sensible decisions based on rational notions and well considered information? Well yes, in a parallel universe called Robot City where machines rule the universe and people are few and far between. On earth however, we have people; emotional beings with decisions based on ‘why’ rather than ‘what’ and a reality that is strongly influenced when greed or fear comes into play.

Behavioural finance is the study of human behavior in economic climates, with the early work in the 1970’s by researchers Daniel Kahneman and Amos Tversky, earning them a nobel prize for their work on the psychology of investment behaviour

Our brain is possibly the most amazing and complex ‘machine’ on the planet. At any given time, our brain is thought to consume roughly 20% of our total energy expenditure. To navigate through the complexities of our everyday human experiences, we have ‘rules of thumb’, ‘heuristics’ or ‘shortcuts’ to assist us with our decision making. Whilst normally serving us in making us more efficient, these rules of thumbs generally help us. However, when it comes to investing, if you’re not paying attention you can be vulnerable to bias, and as a consequence poor investing behavior.

pastore con gregge di pecore sui monti Sibillini, ItaliaHerding

Investors feel a strong impulse to do what others are doing.  Therefore, people put more money in the top of the market and sell after crashes at the bottom of the market.

In consultation with your financial advisor, have the courage to do the opposite to the majority.

Loss Aversion

We rate loss twice as heavily as our gains. We would far rather a scenario where we win $75 than an instance where we win $100 and then lose $25.

For people who are retired and invested, we rate loss 5 x as heavily as our wins.

This becomes a problem for when an investor starts to experience losses – investors often go to great lengths to avoid losses that can mean staying in an investment for longer than necessary just to avoid the eventual loss – even though often eventually losing more. market.

Have limits around your investments. Make sensible goals around when you will stay in and when you will get out. Have a trusted adviser assist you to set these goals. An adviser can help to offer you objectivity, particularly if you are emotionally tied to an investment.

status quo

Memories are short and so we lose perspective

The Status Quo Bias

People generally have short memories for events. For example, if a stock goes down people tend to behave as if they will continue to decline.

Keep sight of the bigger picture.  Research how the shares have travelled over a much longer time frame.

Financial advisors often say that investors take too narrow a view of the market and don’t commit to the longer term strategy that is needed.

Illusion of Control Bias

In committing to a financial investment, investors will gain greater confidence in their decision and believe with more certainty in their decision than may be warranted. The belief that an investor has more control than they do may result in failing to sell a stock, when such a decision is warranted. The best example can be seen on the craps table at a casino, If people want high numbers, they’ll roll the dice really hard, but when they want lower numbers, they roll them very gently!

Look in the mirror! Acknowledge that you are human and that when you open yourself to the possibility that you may be vulnerable to thinking as others do, you may be more likely to avoid biases rather than experience them!

Male hand rolling five dice on green felt

The illusion of control: rolling soft for low numbers and hard for high!

Our greatest bias?

Interestingly one of the most problematic biases we can suffer is when we assume that a bias is experienced by others – but not ourselves.

Look in the mirror! Acknowledge that you are human and that when you open yourself to the possibility that you may be vulnerable to thinking as others do, you may be more likely to avoid biases rather than experience them!

 

So what can you do to invest without falling into the trap of one or more of the investment biases?  To find out how to invest with the approach of a professional athlete, click here.

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