Traditional economic theory suggests that we all make rational choices based on personal self-interest. But research pioneered in the 1960s – and honoured with the Nobel Prize in 2002 – has since shown that this might not be the case.
Not only do we all have the ability to make bad decisions, but they might also be hardwired into our brains.
When you’re investing, these so-called cognitive biases might lead you to over-simplify complex ideas, draw incorrect conclusions, and ultimately make bad decisions.
And because they are hardwired, you might not be able to stop yourself from thinking this way.
What you can do, is acknowledge that the biases exist and look out for them. Take a second look at your investment choices, be objective, and you’ll have the peace of mind that you’ve made the best decision, and for the right reasons.
Here are some cognitive biases to watch out for:
1. Confirmation (or anchoring) bias
You might have a preconceived idea about a certain investment. Confirmation bias will ensure that you actively seek out, and pay more attention to, information that supports the idea you hold.
By not seeking contradictory data – and weighing up the merits of that data – you are not able to build a full and objective picture.
Confirmation bias might also mean that you assign greater significance to one piece of information, over other pieces of information that are equally significant.
Maybe your investment decisions are based entirely on whether a share price is rising or falling?
It’s important to remember that recent price movements tell you nothing about historic performance and whether the current price represents good value.
Take a step back, be objective, and think about the bigger picture.
2. Loss aversion (and endowment effect)
It’s only natural to prefer making gains over losses. But loss aversion describes the desire to avoid the regret that comes from a bad decision. Placing more importance on avoiding losses than on obtaining gains will affect your returns.
If you are influenced by loss aversion bias, you will likely take less risk. You might even find yourself reluctant to sell losing investments because doing so would make that loss ‘real’.
This bias is closely linked to the endowment effect, whereby a higher value is placed on shares that you already own, over ones that you do not. This could see you pass up new investment opportunities with potentially better outcomes, and detrimentally impact on the diversity of your portfolio.
We are all prone to taking mental shortcuts when trying to understand complex issues. It’s an adaptation that speeds up the decision-making process. But oversimplification can also lead to a reliance on assumptions and preconceived ideas that might not be accurate.
Heuristic simplification, as this is known, could mean that you automatically favour the most recent piece of information you hear on a given topic.
Not only will you recall that information more readily, but you’ll also assign it an extra level of importance. If it weren’t correct and important, why would you have remembered it?
You can avoid the tendency to oversimplify by limiting your investments to areas you know well, both in terms of the asset class, sector, or the possibility of future growth.
4. Familiarity bias
We tend to be drawn to things we know. The more we are drawn to them, the more exposure we have to them, and the more familiar they become.
This vicious circle could see you constantly drawn to the familiar.
Not only will this limit diversification in your portfolio, but it could also lead to feelings of anxiety if you consider, or opt for, a less well-known investment outside of your comfort zone.
5. Trend-chasing bias
Also known as the bandwagon effect, or herd mentality, you might find yourself drawn to the investments that others are making. There is comfort in this.
But remember that your investment portfolio is based on your financial plan, which is individual to you.
Past performance is no guarantee of future success. Past performance might be attracting significant investment in the present, but this could represent the trend-chasing bias of others. Being aware that this bias exists, you can approach a new opportunity objectively, being sure it is right for you.
Although cognitive biases are hardwired into our brains, being aware that they exist is the first step to avoiding their pitfalls.
By objectively examining our decisions for signs of bias, we ensure our choices are based on sound logic and a full understanding of the sometimes-complex processes at work.
But it isn’t always easy to step back and view our own decisions from an objective standpoint. Especially at the moment. That’s where financial advice can help.
We are aware of the common mistakes investors can make, and the reasons behind them. We help you build a diversified, long-term investment portfolio aligned with your risk profile and future aspirations.
Get in touch
If you would like to discuss any aspect of your current investment portfolio, please get in touch. Email at firstname.lastname@example.org 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.