When it comes to investing, we all like to think of ourselves as rational beings who are controlled by our heads and not our hearts. But even successful investors can let emotions lead the way with harsh consequences on our hard-earned wealth…..
You may think that you’re one of the fortunate ones who can switch off your emotions when dealing with investment decisions, but ultimately, we’re all human and even seemingly rational choices can be influenced by controlling emotional biases that operate on a subliminal level.
Emotional biases are based on instincts, individual perceptions and moods and can have a significant impact on your long-term investment return. What’s important is to know how to identify them and control them when making significant decisions.
Let’s discuss five of the most common emotional biases.
Loss aversion refers to our inclination to favour avoiding losses over obtaining investment gains. It’s obsession with the risk related to an asset rather than its potential long-term gain.
Do you recognise any of these?
- You avoid selling unit trusts that have increased in value as you’re opposed to paying capital gains tax which you regard as an unnecessary expense and loss
- You’re quick to sell unit trusts that have declined in value in fear of further loss
If yes, you may be struggling with loss aversion.
Familiarity bias is the preference for investments that we’re familiar with, despite the clear gains reaped from diversification.
Do you find yourself doing any of the following?
- You favour well-known brands and avoid lesser-known stocks or unit trusts from boutique providers despite their great potential for growth
- You purchase property which you can “see and feel” even though your unit trust portfolio is also over-weighted in property unit trusts
If yes, you’re likely to be affected by a familiarity bias.
A recency bias is our tendency to believe that something is more likely to occur because it happened in the near past. We believe that if something happened long ago, it wouldn’t happen again.
Do you recognise any of these tendencies?
- You invest in Bitcoin despite its volatility because your friend has recently ‘coined it’
- You avoid all financial advisers as a close friend and family member was recently given advice and their unit trust portfolio subsequently declined shortly thereafter
A Recency bias is much like a confirmation bias which exists as we’re exposed to too much information and can only focus on opinions that support our viewpoints.
Have you ever wondered why?
- We post and read information on social media that makes us feel good! (Ever wondered how many supporters of one political party would rather not follow the views of another via their respective Facebook pages)
- Many Big- city/Inner-city dwellers within UK and USA blinkered themselves from Brexit and pro-Trump media campaigns and were then shocked at the outcome!
We all go about selecting information that in fact strengthens our confirmation bias.
An overconfidence bias is based on a person’s subjective confidence being greater than objective accuracy. You think that you know more than you do and have more control that you do. This bias may work well for you in your personal life in that confidence is a motivator, but it rarely works in an investment context.
If you find yourself doing any of the following, you may be affected by an overconfidence bias:
- Buying and selling unit trusts often even though you may be deviating from your carefully defined financial plan and incurring unnecessary CGT
- Expanding your business and employing more staff without having done your research and prepared a comprehensive business plan
Remember that all overconfident investors are only one trade away from a nasty surprise!
Herding behaviour is our inclination to simply follow the masses, whether the trends are rational or not. Better put, it’s a gang mentality which occurs as we don’t want to be outsiders and believe there must be some sense in the gang’s thinking (whether we subconsciously agree or not).
If you’ve done any of the following, there’s a good chance you’re affected by the herding bias:
- Blowing your Festive Season budget as ‘celebration is in the air’
- Moving money offshore despite the exchange rate
The herding bias explains bull and bear markets: when markets rise, we keep buying and demand pushes prices up, and as markets fall we sell, and the increased supply leads to further fall.
We can’t void ourselves of these biases as we’re human but can analyse our behaviour before we invest or sell.
The best ways to assist you to stop emotional biases in their tracks is to:
- Discuss your financial decisions with a Kanan Wealth advisor in order to maintain objectivity
- Keep records of your investment decisions and the emotional circumstances at the time and learn from your past behaviour
- Learn from different sources and value others’ opinions
On a final note, do thrive on all the positive emotions that come along with the Festive Season!
From all of us at Kanan Wealth, we wish you a safe and happy holiday.