Investment returns are affected by a huge range of issues. Fees, stock market returns, legislation, politics and tax are just a few – but what if your own emotions also affected the returns you receive on your savings?
Recent research from an American robo-adviser Betterment found that, on average, investors sacrifice between 1.4% and 4.3% in annual returns by letting their emotions get in the way of good investing.
Scientists have long studied the psychology of investing, so here are three ways in which your own brain could be affecting the returns you receive.
1. Loss aversion
Daniel Kahneman, winner of the 2002 Nobel Prize in Economics, wrote that ‘the concept of loss aversion is certainly the most significant contribution of psychology to behavioural economics’.
Loss aversion relates to the theory that we fear losses more than we value gains, even if the amounts gained and lost are the same.
Here’s an example. Imagine you are offered either a guaranteed £2,000 or a 50/50 chance of winning either £2,000 or nothing at all, based on a coin toss. Most people choose the guaranteed £2,000.
Loss aversion suggests that we are not acting entirely rationally when we make investment decisions as losses hurt us more than gains please us. Research shows that people will more often choose to sell their winners and hold their losers, hoping they can recoup the investment over time, even though this may lead to more losses.
In conclusion, the fact that we fear losses more than we value gains could lead us to take less investment risk than we could tolerate or would be suitable. It can also explain why we might not sell losing investments, as we don’t want to confront the fact that we have made a loss.
2. Sticking with the familiar
In your day-to-day life, you’re probably guilty of sticking to what you find familiar. According to a 2018 poll, one in six workers admit they have eaten the same lunch for at least two years. Maybe you take the same route to work, or you always buy the same brand of toothpaste?
“We have a greater affinity with things we can pronounce and relate to,” says Lisa Kramer, a University of Toronto professor who specialises in behavioural economics. “You’re drawn to the familiar.”
This ‘familiarity bias’ sees individuals prefer to remain within their comfort zone. Humans have a tendency to believe more in the choice that they recognise and are aware of, whereas unfamiliarity makes them uncomfortable and unsure.
This bias is common in investing. Investors generally prefer buying shares that they are familiar with, such as shares in their own employer or in companies whose products they regularly use.
For instance, when presented with a choice between buying shares in Apple or Synaptics, investors are more likely to choose Apple. This is because they are familiar with the company and use its products more often.
What this bias means is that you are potentially avoiding investing in lesser-known companies and shares, which may turn out to be more profitable than more familiar options.
This bias can also mean that your portfolio may not be as diverse as it should be. Your asset allocation will be restricted to familiar shares and your returns may therefore suffer.
One way to overcome this bias is to seek help with your investment. Taking a second opinion from a professional can help you to become aware of other opportunities and to diversify your portfolio.
3. Confirmation bias
As the old saying goes: ‘You never get a second chance to make a first impression’.
First impressions can be powerful as we can be guilty of selectively filtering. We pay more attention to information that supports our initial opinion and we ignore other viewpoints.
In investment terms, confirmation bias would occur when an investor is more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it.
This can create a problem for your investment returns. For example, when researching an investment, you might look for information that supports your beliefs about the investment, and fail to see the information that presents different ideas. This can lead you to make poor decisions, whether it’s in your choice of investments or your buy-and-sell timing.
Here’s an example. If you have heard a rumour that a company is struggling, you might consider selling their shares. When you look for more news about the company, you might only read stories that confirm the likelihood of administration or bankruptcy.
You may miss stories about a new product the company has just launched which is expected to increase performance and profits. So, instead of holding the share, you sell it at a loss just before business improves and the share price rallies.
To overcome this bias, it’s useful to seek alternative ideas about an investment and to review the pros and cons to reassess it with an open mind. Asking your financial adviser for information can also be useful, as their opinion can be used to help you reach an unbiased conclusion.
Get in touch
Your financial planner can help you overcome many of the psychological biases common in making investment decisions. Please get in touch to find out how we can help. Email email@example.com or call 0800 0787 182.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.