Investment Psychological Traps
One of the biggest problems’ investors face – is themselves! A degree of emotion plays into our financial decisions. There is even a discipline devoted to understanding how our emotions affect our financial choices. It’s called, behavioural finance. Examples of emotionally driven financial behaviours are all around us, especially in the investment markets.
Below are 5 psychological traps people fall into when making investments.
LOSS AVERSION
This refers to a bias in human psychology where we tend to prefer avoiding loss than acquiring equivalent gains. For example, we’d rather not lose $100 than to gain $100. We tend to focus on what we might lose, as opposed to what we might earn. We saw this during the period of market volatility in late March, which saw some investors cashing out in a bid to protect a portfolio’s existing value. Thus, these investors were less likely to have benefitted when the Australian share market quickly moved back and regained much of those initial losses. One way of addressing this is to frame your portfolio gains and losses as wide as possible and over a long-term horizon and not take a narrow view at one point in time.
CONFIRMATION BIAS
This bias refers to when we look for information which supports our beliefs or choices. Actively seeking out information that reaffirms your theories on a given scenario or ignoring any data that contradicts these beliefs can hinder your investment goals. Selectively choosing which information to use can lead to a lack of diversification and investments that are too risky. For example, a client who is committed to owning shares in a particular company may ignore unfavourable news about that company. This can lead to clients investing too much in a particular sector. Combatting confirmation bias requires open and effective communication. You can set up systems to help override cognitive impulses around making investments. These strategies will help you avoid making sudden investment decisions driven by their confirmation bias.
HERD BEHAVIOUR
We’ve all heard about (pardon the pun) buying low and selling high. Yet, many investors end up doing the opposite. This is due to the herding bias which makes us want to follow the crowd. Some investors may sell at low prices as the market is falling to avoid more losses despite the investment being sound and beneficial for long-term objectives. They may also miss out on true buying opportunities due to a fear of negative market sentiment continuing the downward trend. Rather than following the crowd, ensure you consider your unique circumstances and investment goals when executing your strategy.
FAMILIARITY BIAS
This bias encourages you to make investment choices that are considered “friendly” and comfortable to you even if they are illogical. 75% of Australian retail investors only hold domestic shares. Meanwhile, Australia makes up less than 3% of global market capitalisation. This is a common trend regardless of what country you reside in. This can lead to unintended concentrated risks in portfolios and, at worse, poorly diversified portfolios. The worst part of the familiarity bias is it hits hardest during times of stress. Familiar companies will feel safer than unfamiliar companies during times of recessions or financial market crises. However, what makes a company safe is how forecastable its future financial results are.
ANCHORING BIAS
Looking at past history is a distraction and can lead to attitudes like “not selling because the price is down”. It can be dangerous for investors to look in the rear-view mirror and try to pick winners based on the last few years. One way to avoid anchoring is to not record your cost based in your list of shares so you cannot readily see how much you have made or lost on a particular stock. It is important to focus on the company rather than the stock. Ensure your decision is based on whether a particular price is good based on the future and see if the company is becoming more relevant to more people.
NEED HELP WITH INVESTMENTS?
Cognitive biases are often hard to detect because they occur so naturally. However, learning and recognising how they can affect your decision making, will be useful for every investor, especially in times of uncertainty. Understanding that we are all subject to biases as an investor demonstrates the power of having a financial plan that captures your personal and financial goals. It is much easier to make decisions if you have taken the time to create an investment strategy which is tailored to your investment objectives. If you need help with developing a strategy or simply want an objective opinion, speak to one of our financial advisors by clicking on this link.
– 27 January 2021 –
General Advice Warning
In preparing this article, Praescius Financial Consultants NSW Pty Ltd, Praescius Financial Consultants NT Pty Ltd, Praescius Financial Consultants HB Pty Ltd and Praescius Financial Brisbane Pty Ltd have not considered your personal circumstances, goals or objectives; as such the information, commentary and assertions made within this article may not be suitable to you. Please seek personal financial advice prior to acting on this information, or making a decision regarding the choice of a financial product or strategy. Further information and disclosures can be found in our Financial Services Guide or by contacting us on the phone numbers provided.
Praescius Financial Consultants NSW Pty Ltd, Praescius Financial Consultants NT Pty Ltd, Praescius Financial Consultants HB Pty Ltd and Praescius Financial Brisbane Pty Ltd are authorised representatives of Praescius Financial Holdings Pty Ltd ABN 14 610 960 980 AFSL 486455, 2a/57-59 Oxford Street, Bulimba Qld 4171.
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