Emotional bias and investing
Beating the bias
We all like to think of ourselves as rational human beings making reasonable decisions in our day-to-day lives. However, social scientists assert that this is almost never the case when it comes to how we invest our money. This is because when we are faced with complex decisions, our minds are hardwired to take "shortcuts" and our feelings tend to get in the way.
We saw this first-hand during the early stages of the pandemic. Long-term investors panicked on the back of the decrease in prices in March and let emotion overpower the key long-term rule of staying the course and giving investment strategies enough time to perform.
These issues are so common in investment decision-making, that they carry their own unique terms. The shortcuts our brains take when making investment decisions are termed cognitive biases and the fact that we let our feelings dictate our decision-making is called emotional bias.
Cognitive bias
Cognitive bias involves using mental shortcuts or "rules of thumb" to make decisions. The problem is that these rules of thumb may or may not be accurate. We highlight some examples below:
- Confirmation bias: 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: 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: 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: This 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 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"): This 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
Emotional biases occur spontaneously and naturally when an important decision is being made. These biases are usually ingrained in the physiology of investors due to an individual's personal experiences and can be harder to overcome than cognitive 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: This goes together with loss-aversion bias - investors often feel that what they currently own is more valuable than what they do not. This could result in remaining invested in a certain stock, where other shares or assets have better prospects for growth.
- Overconfidence bias: Perhaps owing to past success, an investor may have too high a regard for their own investment 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: Self-control bias results in investors deviating from their savings and investment plans, often through making erratic buying and selling decisions without considering the underlying fundamentals of the investment.
- Regret aversion: Investors avoiding 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. The team at FNB has the tools to overcome these emotional and cognitive biases and invest for the long term based on sound fundamental reasoning. Utilising a portfolio manager or financial advisor removes emotional decisions and rather leaves the decisions to an unbiased financial mind. Seeking financial and investment advice can provide a valuable outside perspective that could help you avoid making biased decisions - either by reminding you of your goals, risk profile and strategy or by providing you with the information required to make more informed decisions.
