Behavioural Biases in Investing (How to cope with being your own worst enemy)
Behavioural biases could be the biggest barriers to you becoming a better investor.
Your behavioural biases can cause you to sit on the sidelines. They can cause you to buy or sell at the wrong time. They can cause you to choose the wrong investments.
“The investor’s chief problem – even his worst enemy – is likely to be himself.”
– Benjamin Graham
In this article, we’ll explore what behavioural biases in finance are, how behavioural biases affect financial decision making, how to identify your own behavioural finance biases and most importantly, what tools you can use to overcome your biases and become a better investor.
What are behavioural biases?
Are you a robot?
If not, then you will have behavioural biases.
Behavioural biases are human traits that cause your decision-making to deviate from logic and reason.
Economists such as Nobel prize winner Richard Thaler have advanced our understanding of how investors behave, and they are not the purely rational actors that traditional economic theory proposed.
Your emotions, personality traits and mental mistakes all play a part in affecting your financial decision making. They are unavoidable, but being able to identify your own biases can help you to avoid letting them dictate your investment decisions, and ultimately make you a more successful investor.
Let’s take a look at some of the most common behavioural biases in finance.
Some investors may exhibit overconfidence, both in the quality of information at their disposal, and their ability to interpret and act on that information. It can cause their portfolios to be insufficiently diversified because they believe so strongly that they are right, that they put all their eggs in one investing basket.
This overconfidence can further lead to self-attribution bias, where the investor attributes successful outcomes to their own performance and negative outcomes to external factors out of their control. They believe they have a golden touch.
Conversely, underconfidence can cause investors to be reluctant to start investing because they don’t feel confident in their financial knowledge. Underconfident investors can also lack the courage to stay the course, causing them to panic sell when their investments decline in value.
Loss aversion bias
Did you know that the pain of losing is psychologically twice as powerful as the pleasure of gaining?
So you’d need to find $20 on the street to make up for the disappointment you feel from losing $10. This behavioural bias means that investors are twice as likely to sell a winning position too early. They would rather lock in a ‘good’ gain, and avoid the chance of a future loss, than to hold out for a ‘great’ gain.
It also causes investors to sell a losing position too late. They hold on, hoping that their luck will change and they won’t have to sell at a loss. But the situation often worsens and they end up taking an even bigger loss.
In summary, loss aversion causes investors to take insufficient risk on the upside, and accumulate bigger losses on the downside.
There are thousands upon thousands of stocks that you could choose to invest in. Many more than you could ever investigate thoroughly. So humans are naturally inclined to favour stocks they have already heard of. Stocks they have read about in a blog article, or seen on TV, or been told about by a friend or family member.
But this bias means that many investors miss out on potentially much more lucrative stocks simply because they never come onto their radar.
Trend following bias
This behavioural bias is the result of one of our most natural human instincts – the ability to identify patterns. We believe we can look at data and predict the future. We’re always looking at charts to see what stocks are performing best right now.
But all investments come with the disclaimer that “past performance is not indicative of future results” for a reason. The markets are far more random than we like to believe. And even if we do hit upon a pattern or trend, the markets are likely one step ahead of us and have already factored it into the stock price.
The tip of the iceberg of behavioural biases
These are just 4 of the most common behavioural biases.
We’re also subject to:
- Confirmation bias (we give more importance to information that upholds our existing beliefs rather than countering it)
- Bandwagon bias (we believe something simply because many other people also believe it)
- Anchoring bias (we put more importance on the first piece of information we learn about a topic)
- Status quo bias (we resist change and want things to stay the same)
- and many more.
How can you stop your behavioural biases sabotaging your investing?
You may have noticed some of your own traits in these behavioural biases. You’re not alone. Everyone has them.
But as anyone who has tried to kick a bad habit knows, it can be very hard to change your behaviour, especially because many of these cognitive biases are so ingrained that they are part of our personalities.
So if you can’t change your behavioural biases what can you do?
Reduce the effect of your behavioural biases by letting data-driven technology make critical investment decisions for you. taking critical investment decisions out of your control.
ETFs are the perfect tool for this situation.
What are ETFs?
You can think of ETFs (or Exchange Traded Funds) as being like big bundles of assets (typically stocks, but there are also ETFs for other assets such as Bonds and Real Estate).
Instead of picking individual stocks to buy – and therefore introducing many of your behavioural biases – you buy a big bundle of stocks in an ETF. The ETF could include all of the companies in an Index such as the S&P 500. Or it could be a selection of stocks from a particular industry segment. Or it could follow a thesis such as companies who are environmentally and socially responsible.
But whatever ETF you choose, the benefits are immense. ETFs increase the diversification of your portfolio and they reduce the impact of your behavioural biases by taking many of the key decisions (for example which stocks to choose or when to buy or sell) out of your hands.
But you can go one step further in eliminating behavioural biases
Investing in ETFs still requires investment decisions from you, and therefore doesn’t completely eliminate the impact of your behavioural biases.
For example, as you go through life, your financial goals and risk tolerance will change. A 30-year-old is likely to prioritise portfolio growth, whereas someone approaching retirement is likely to want a lower risk portfolio with less chance of losing everything they’ve built over the years.
This requires portfolio rebalancing – changing the makeup of your portfolio over time. Which introduces your behavioural biases and therefore means you might not make the best objective decision.
It also requires you to accurately determine your own level of risk tolerance at each stage of life, and accurately assess the risk of the ETFs that you invest in.
The best solution for you may therefore be to use a Robo-advisor like ETFMatic. Robo-advisors help make investment decisions for you in an informed, objective manner, unlocking better portfolio performance. ETFMatic’s Robo-advisor will determine the appropriate ETFs to invest in based on your own circumstances, and will automatically take care of issues such as portfolio rebalancing.
ETFMatic offers all the benefits of a personal fund manager, but with much lower management fees, meaning that you get to keep more of your money.
To learn more about ETFMatic, click here.