Taking emotions out of investing
By Lorna Tan
If you don’t have time to read through the whole article, you can check out our short version below.
- Being aware of investor biases can help us make less emotional decisions and better choices.
- Do your own due diligence and ask yourself why you are making the investment and see if it aligns with your risk appetite and financial objectives.
- Adopt a diversified investment approach across asset classes and practise dollar-cost averaging to ride out the market volatility and reduce risk over time.
When we are asked to justify our investment decisions, we would like to believe that we have a sound rationale. But studies on behavioural finance tell a different story.
For most retail investors, the impulses to park our savings in investment A rather than B may stem from several sources, past experiences, information from peers, or just out of greed or fear. Studies on the influence of psychology on an individual’s financial choices and the subsequent effect on markets indicate that it is not easy to take emotions out of investing.
Being aware of investor biases can help us make less emotional decisions and better choices. And financial advisers have a role to play to spot such traits in investors and prevent costly mistakes.
Here are 8 common investor biases and tips to counter them.
1. Herd mentality
Our cavemen ancestry as hunters and gatherers with the herd mentality of safety in numbers, worked in their favour back then. But it is usually not so in today’s investing world.
Some investors take comfort when observing that many others are piling into an investment. So they follow the herd without doing careful research first or assessing if the investment suits them. But herd mentality can result in substantial losses.
Some of us can recall the dawn of the internet in the 90s. As soon as investors realized the internet could be monetized, they began pouring their hard-earned savings into different online (dot-com) companies. However, many of these investments turned out to be pure speculation, resulting in the infamous dot-com bubble which burst in the early 2000s. This is because these companies often didn’t have a product to begin with, resulting in many of such companies going bust and investors losing their millions.
Another example is cryptocurrencies. The bitcoin rage sent the digital currency’s unit price rallying sharply to a high of about US$19,000 in December 2017. Those who were drawn to the cryptocurrency mania would have suffered substantial losses as the unit price collapsed after the speculative bubble burst.
It is always important to do your own due diligence. Ask yourself why you are making the investment and see if it aligns with your risk appetite and financial objectives. Be extra careful when you hear too much hype about an investment that has already rallied sharply. As Warren Buffett said: “Be fearful when others are greedy and greedy when others are fearful.” If you wish to speculate, do so with savings that you can afford to lose.
2. Confirmation bias
Investors tend to seek information that supports their beliefs and ignore contradictory data resulting in a one-sided decision-making process. For example, an investor buys a stock and pays attention only to positive news and reports while ignoring negative ones. That could lead to his sticking to a one-sided view and buying more of the stock despite warning signs.
While it is important to conduct research to validate your investment thesis, it is equally important to look for counter arguments and evaluate them honestly. One way to mitigate this bias is to read widely and consider information from multiple sources. Doing so will lead to a more objective perspective when evaluating an investment. In addition, keep an open mind about alternative views that may contradict your belief.
This occurs when investors overestimate their investment ability. For instance, few investors would rate their stock-picking accuracy as below average. And despite the advantages of diversifying a portfolio, overly confident investors may hold portfolios that are too concentrated. Believing that they can predict how prices move, these investors may also incur high costs due to excessive trading.
Let’s assume an investor trades stock A and consistently makes good profits from his initial trades. Thinking he is unbeatable, he buys more of stock A as his confidence grows and the stock price rises. Conventional wisdom would have called for caution, given that the already significant rise in the share price would have made valuations less compelling. Instead, he becomes overconfident and makes a sizeable purchase hoping for a substantial gain.
When markets suddenly turn against him due to an external shock like a global financial crisis, he refuses to accept reality and holds on to his position in stock A, or worse still, adds on to it as markets fall. Such an investor will usually find it hard to cut his losses because cutting losses would mean wiping out all his gains from his initial trades and it’s something he can’t accept.
Stay objective and do not take on excessive and concentrated risk. Careful research and diversification are ways to reduce risks that come with overconfidence bias.
Anchoring occurs when there is a fixation on a data point, usually the price of shares or funds. An investor may have invested in a fund at a certain price per unit and then sold for a decent profit. That price becomes an anchor price and the investor develops an unwillingness to invest at a higher one, though the fund may have grown over the years and is the best vehicle for the current market.
To reduce this bias, comparing past and present data on elements such as quality of assets, cash flows and dividend yields. Doing so will make the value of the investment more apparent and dispel the notion that the price is too high.
5. Loss aversion
Our brain is wired to avoid all threats, and they include financial pain. As such, loss aversion can manifest in being more prudent with your portfolio and choosing to invest in seemingly safer investment tools such as endowment insurance and fixed deposits.
As a result of this bias, investors also tend to sell their winners too early and keep their losers too long.
This is because individuals tend to be more sensitive to losses than gains, feeling the pain from losses more acutely than the joy from gains. In fact, empirical studies indicated that losses are weighted about twice as much as gains. This means the loss of satisfaction of losing $100 is about twice the satisfaction of gaining $100.
This fear of losses can result in the inability of investors to cut their losses, such as holding on to funds even though the likelihood of a recovery in value is low
Try to understand the reasons behind a loss. If the fundamentals of the investment have worsened considerably, the position is likely to worsen further. When that happens, it is prudent to exit and avoid further losses. Advisers can help investors attain an optimal allocation of resources by presenting alternative investments with stronger fundamentals that can improve the portfolio performance.
Another tip is to do careful research before investing. In addition, adopt a diversified investment approach across asset classes and practise dollar-cost averaging to ride out the market volatility and reduce risk over time. This also means understand the relationship between risk and reward, and your risk appetite before buying investing.
6. Mental accounting
This occurs when investors separate their money into different accounts which may result in irrational decisions. An example is when an individual would rather continue to owe an outstanding amount to his credit card company rolled over every month at an annual interest rate of say 20% even though he has savings to pay off the bills entirely. He suffers from mental accounting of wanting to see cash in his bank account when he would be in a better off financial position if he had paid off his high interest rate incurring credit card debt.
Consider your finances holistically. This means understanding what your personal balance sheet is and being able to analyse how one financial decision affects another. After all, money is money no matter where it’s from and where it’s lost.
7. Recency bias
Some investors tend to latch onto the direction of market movements during periods of strong momentum, jumping to the conclusion that this momentum will continue. They may even project past performance linearly into the future, even though markets usually do not move in a linear fashion.
This explains why some investors are very open to investments that have recent positive performance, even if they are not projected to perform as well in the future, and vice versa.
Take a longer view of your investments and not put too much emphasis on recent events. In addition, understand how different asset classes perform through economic and market cycles. A firm grasp of the relative value of the asset class in the current cycle and its likely performance in the coming phase will give you the confidence needed to invest for the long term.
8. Home-country bias
There is a tendency for investors to invest in stocks, bonds and financial assets in their own country because of familiarity with companies in their own backyard. For example, when your shares portfolio is solely in Singapore-listed companies, it reflects a home-country bias. Investors often confuse familiarity with knowledge, and therefore suffer from overconfidence with investments they are more familiar with.
Never put all your eggs into one basket because things can go wrong with the economy and financial markets at home, and it makes sense to reduce this risk by diversifying geographically. You may be inadvertently taking on more risk than you realise especially if you are employed in your home country and have bought a house there and invested in other properties as well. To mitigate this bias, consider global investment opportunities that you are missing out by being too home centric.
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