How to address the brain's biases during and after the pandemic
Are you in danger of going with the herd? Turbulent markets can prompt emotional, rather than rational, behavior. We share how to diagnose and defy your own "investor biases".
Covid-19 has led to some of the most volatile financial markets in recent history. In times of such great uncertainty, it’s common for us to make emotional, not entirely rational, decisions. We can yield to our emotions in different ways, and these are called “biases”. Being aware of how this can manifest in investing could help you make better financial decisions.
As Aristotle put it: “Knowing yourself is the beginning of all wisdom”.
Overconfidence bias – are you better than all the rest?
Overconfidence bias is the tendency for people to be more confident in their own ability than is reasonable and realistic.
Indeed, in many cases people view themselves as above average; a well publicised survey on American car drivers that found 93% rated themselves as above average.
Now imagine you have just had a run of picking some winning shares or investment funds. If you are affected by overconfidence bias, you will likely conclude that the success is down to your investment skill rather than luck. Interestingly, in the opposite scenario – when things don’t go well – people tend to frame this the other way round: they say the negative outcome is down to bad luck rather than their lack of skill!
Such success may encourage you to take greater risks, as you have a misplaced certainty that your skill will result in success time and again.
While this may lead to higher rewards, unfortunately it's equally likely to result in greater losses.
To address this, do your homework. Don’t skip the sound background research because you think you can’t go wrong with your inimitable skill or you think you already know how a scenario will play out.
Carefully consider the downside effects of being wrong, and the very real possibility that you might not be better than all the rest.
Confirmation bias – do you look for those who agree with you?
Confirmation bias is the tendency to search for, and favour, information that confirms your beliefs.
As Warren Buffett, perhaps the world’s most celebrated investor, famously said: “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.”
We are twice as likely to look for information that agrees with us than we are to seek out evidence that does not, according to Ray Dalio, another famous investor who wrote the book Principles: Life and Work.
This is not as startling as you may think – it’s in our nature to enjoy being right and hate being wrong, so we naturally gravitate towards information that confirms how right we are.
For example, you may have a pre-conceived belief about the return potential of a stock, sector or style. As a result you might be more likely to search for evidence that supports this notion, rather than for evidence that doesn’t. Even when presented with opposing information, we may choose to reject or fail to fully appreciate it.
This bias is prevalent in many facets of life, and can explain why two people can see the same evidence but come to different conclusions.
Some of the greatest investors try to overcome this by actively seeking out those with different opinions to them.
This subtle change of emphasis from wanting to be correct to the desire to know what is correct can have profound implications.
Loss aversion – does the pain of losing affect you more than the pleasure of winning?
Loss aversion is an emotional bias that involves taking action (or failing to take action) to avoid a loss. It boils down to the theory that losses are more painful than gains are pleasurable. Or, put even more simply: “losses loom larger than gains” for people.
Those displaying loss aversion bias when making investment decisions tend to focus more on the downside while giving less weight to the potential upside.
This can lead to investors holding onto falling investments for too long in fear of crystalising a loss. Similarly, we may sell rising investments too soon for fear of losing gains.
To address the former, it could be a good idea to implement a strict stop-loss policy that will limit your losses to a manageable amount. For the latter, the opposite could work: figure out a reasonable target price at which you’d be happy to sell your investment. In either case working out your risk tolerance is crucial.
Herding mentality – are you unduly influenced by others?
Herding mentality is the tendency to be influenced by the behaviour and decisions of those around us.
This is much the same as FOMO (“fear of missing out”). How many of us have ended up buying the latest iPhone just because our friends have? Simply put, we don’t want to be left behind.
In investing, herding mentality can cause “bubbles” to form. Just look at what happened in the Global Financial Crisis and dotcom crashes. More and more people jumped on the bandwagon and piled into the property and technology sectors respectively, values became inflated, eventually leading to market crashes that devastated millions.
Bubbles are by no means a new phenomenon. One of the most studied cases of price bubbles involved the frenzied trade in tulip bulbs in 17th century Holland. As the chart below shows, the mania for certain types of tulip was so extreme that single bulbs were worth more than large properties. In today’s money, tulip prices reached approximately £800,000. But they crashed back to earth when speculators suddenly became frightened and ceased buying.
However, it is worth noting it can be emotionally difficult, and take significant courage, to go against the crowd (or taking the “contrarian” view as it is called). This is not to say group decision making is in itself a bad thing – in fact, it is generally more likely to lead to better decisions in normal circumstances.
What is dangerous is blindly following and imitating others for no reason. In doing so, we may not know the full extent of what we have committed to.
For this reason, it is essential to understand what makes a good investment decision for you, not just because it’s the latest fad or trend. In doing your homework, you might find that not joining in the recent trends – as emotionally painful as it may be – can stand you in good stead in the long run.
Objective thinking in times of uncertainty
Behavioural biases can hinder our ability to make sound investment decisions, particularly in such an uncertain investing environment.
It’s far easier said than done, but addressing your biases and making objective, sound judgments could make the difference between a successful and a poor investment decision.
Take the Schroders InvestIQ test if you’re interested in finding out more about which biases may affect your investment decision-making.
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