In our quest to make money through investments, we sometimes sabotage our efforts by using our emotions, instead of logic, to make financial decisions.
And this is not surprising since investing money can be a complex, mind-boggling, intimidating process. Many fear making costly mistakes and this comes from a lack of background, education or experience in making wise financial decisions.
US-based financial research firm Dalbar says the two most common emotions that motivate us when we invest are fear and greed.
Motivated by greed, most investors invest when the market is bullish and they feel safe, which is why investors do not make money from the stock market. Pushed by fear, investors pull their money out when prices start plunging. Anxious and worried, they liquidate their investments and sell at low prices.
Investors then feel remorseful as the market recovers and then wait too long before getting back in.
This rollercoaster of emotions is in fact against one of the basic tenets of investment advice: buy low and sell high.
So, what are the common behavioural biases that affect our decisions?
As laypersons, we often think we know more than enough about investing when in fact, we don’t have the knowledge that financial experts have. Overconfidence comes in two components: thinking you know more than enough about the quality of your information, and your ability to act on that information for maximum gain. Studies show that overconfident traders trade more frequently and fail to diversify their portfolio.
Frequent trading, in fact, does not lead to higher returns. Studies conducted have concluded that more active retail investors make less money.
2. Myopic Loss Aversion
Fearing losses can be a greater motivation than reaping profits. Because of this fear, people strongly avoid losses, rather than focus on acquiring gains.
Usually, these investors have a habit of checking their stock portfolios often. Once they see that they are losing money, they decide to sell everything off.
3. The Anchoring Effect
Instead of relying on fundamental factors to make decisions, investors rely on the first piece of information they are exposed to. This information acts as the anchor that causes irrational decisions. They use this fixed viewpoint and apply it as a reference point for assessing future decisions.
For instance, when a financial crisis occurs, they use that as the basis for anchoring their decisions and become risk and loss-adverse for all their investments, leading them to underweight equities in their portfolios.
4. Reducing regret
Regret is a common human behaviour and this is experienced as well when making investment decisions. Let’s say you bought a certain stock that was value-priced and had little downside potential. But the value decreases. You don’t want to feel regret with your purchase, so you continue to hold onto it and don’t sell the stock until you lose a majority of its value.
By locking in a loss, an investor does not have to deal with regret. Research shows that traders were 1.5 to 2 times more likely to sell a winning position too early and a losing position too late, all to avoid the regret of losing gains or losing the original investment.
5. Home Bias
Going local is good, but only to a certain extent. Most investors fail to explore stocks outside their home country, which could also be profitable, simply because they prefer to stick to local stocks that they’re more familiar with.
6. Confirmation Bias
As humans, we have the tendency to seek an opinion that sides with what we believe in. This is the same in investment. We seek opinion or interpret facts in a way that suits our world view, and as investors, we seek confirmation for our investment assumptions. Thus, many investors avoid looking at different views and shun critical but possibly valuable information and reports.
What should we do to avoid these biases and invest wisely using logic and common sense?
1. Accept that others know more than you
Instead of thinking that you know more than others and believing too much in the information and intuition you have, understand and accept that you’re trading against computers, institutional investors and others around the world with better data and more experience than you. Trade less and invest more. By increasing your time frame, mirroring indexes and taking advantage of dividends, you will likely build wealth over time.
2. Know your psychological biases
It’s very important to know yourself as an investor. What is your risk appetite, your investment timeframe and objectives, your money habits? Do you usually jump into trends, instead of carefully studying the market? Do you often react to market noise? Ask yourself if you are self-sabotaging your investments because of your behavioural biases.
Related: 7 Habits of Successful Investors
Once you’re aware of the answers to these questions, work on the steps to achieve your goals. You also need to have the drive and commitment to want to change your biases. You may need to engage a financial planner who can guide you more and advise you against investment decisions based solely on your biases.
3. Don’t time the market
Because of the rollercoaster of emotions that come with behavioural biases, investors tend to switch in and out of funds at the wrong time, selling low-performing stocks cheaply before a recovery, and moving on to high-performance ones just before a fall.
Know, understand and accept that market volatility is part and parcel of investing.
You could do dollar-cost averaging, which means investing in smaller, regular amounts via a savings plan, regardless of fluctuating price levels. Dalbar found that investors who practise dollar-cost averaging reap 50% higher returns.
4. Learn on your own
One way to overcome your own behavioural biases is to study and acquire knowledge about financial planning and investing. You could gain a financial education through short courses or online studies, and you should research, study and analyse before you jump into the market-driven solely by your emotions and biases.
5. Take the Warren Buffett approach
Instead of buying when stocks are high and selling when they’re low, do it the “Warren Buffett way,” which is a tried and tested approach: buy when others are fearful and sell when they’re confident. Don’t follow the herd, as this rarely produces large-scale gains.
Also check out: [Infographic] 6 Things to Learn About Money from Warren Buffett