Much of traditional economic and financial theory is based on the assumption that individual investors act rationally, that they’re able to analyse all available information when making their decisions., and that markets are efficient as a result.
But this is rarely true in reality.
Individuals have neither the time nor the ability to do this. Instead, we strive to make decisions that are ‘good enough’ by simplifying the choices available. And this is where emotional biases can creep in. These relate to feelings, perceptions, or beliefs about certain elements and can be a function of reality or the imagination.
This is a huge topic that comes under the banner of behavioural finance, which seeks to challenge traditional economic theory. It explores how people behave and how emotions can result in suboptimal decisions not only at the individual level but driving broader market anomalies too, such as sharp rises and falls in share prices.
In this week’s blog, I focus on the main emotional biases in investing, how these can cloud one’s judgement, and how to overcome them.
Common emotional biases in investing
1. Loss aversion
This is the big one.
Loss aversion is the tendency to feel more pain from losses than pleasure from gains.
For example, the anxiety around a -10% stock market decline is often much more severe than the pleasure of a 10% gain.
This bias can impact investment decisions, causing investors to hold onto losing positions for too long, or sell winning positions too early, resulting in minimal returns.
2. Confirmation bias
This is a natural human tendency to seek out information that confirms our existing beliefs and opinions, whilst ignoring any information that might challenge them.
Or put another way, only focussing on the good news, whilst ignoring the bad.
The result is holding onto a position when the investment case has turned.
3. Endowment bias
The endowment effect describes how people tend to value objects they own more than objects they don’t.
This is often observed where investments have been inherited from a deceased relative. People exhibit the endowment effect by refusing to divest those shares, even if they do not fit with the broader investment strategy or risk profile, and may adversely impact a portfolio’s diversification.
4. Recency bias
This is where investment decisions are based on recent events, expecting that those trends will continue.
This can lead to irrational decisions, such as ‘piling in’ after a period of strong market gains or selling out at the lows.
This is a hot topic at the moment following a prolonged period of outperformance for US stocks, specifically the ‘Mag-7’ US tech behemoths. There is a growing chorus of US investors calling an end to international diversification (i.e. ‘why own non-US stocks’?), meanwhile, I’ve had several conversations with UK investors asking whether we should be ‘doubling down’ on the US.
5. Overconfidence
Overconfidence is the tendency to overestimate one’s abilities to predict market movements and make investment decisions, leading to excessive risk-taking.
This often arises after a period of strong market gains (such as now for example) and the perception that it is one’s stock-picking ability that has driven recent gains, rather than a broader ‘risk-on’ phase – a rising tide lifts all boats.
An overconfident investor may increasingly concentrate their portfolio on a few stocks, leading to a high degree of risk-taking and the potential for significant losses.
6. Anchoring
This is when investors fixate on a reference point, such as a stock’s price.
For example, refusing to sell at a loss, or waiting for a ‘big figure’, e.g. “I’ll only sell above £100”.
Similar to confirmation bias, this can cloud one’s judgement, resulting in positions being retained even if the fundamentals have deteriorated.
7. Familiarity bias
Finally, the familiarity bias is when investors tend to invest in what they know, such as domestic companies or global brands that they use every day.
I’ve written previously about the UK’s falling share of the global stock market, now just 4%. Yet we often come across DIY portfolios that are mostly, if not fully, made up of domestic stocks. This can be a major drag on portfolio diversification and translates to an increase in risk profile.
Disclaimer: When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
Overcoming emotional bias
The above might sound quite ‘preachy’ – a list of common human errors which can lead to sub-optimal decision-making when managing your portfolio.
But building and managing your portfolio (particularly one made up of direct equities, i.e. single company shares), and overcoming such emotional biases that are ingrained in human nature, is hard. I know from experience having previously made all of these ‘mistakes’ with my own investments, often more than once.
The way to overcome these emotional biases is to recognise them and take action accordingly.
Personally, I favour a rules-based approach. One that uses funds rather than direct equities, and that largely tracks the market but with a tilt towards i) smaller companies vs large, ii) cheaper companies vs expensive (i.e. value vs growth), and iii) consistently profitable companies vs non/low.
This systematic approach is well diversified, extremely low cost (by using mostly index-tracking funds) and also counters any emotional bias as investment decisions are based on pre-determined rules.
This is the same solution that I recommend to most clients – ‘eat what you cook’ as they say.
Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
