During times of stress, clients sometimes feel the urge to pick up the phone and make rash investment decisions. The stress may be the result of personal circumstances, market turmoil, world events, or even from having had a persuasive conversation with friends.
Investor psychology can have an impact on long term returns. Humans tend to make biased and irrational decisions based on emotion, habitual behaviours and past experiences. By having a basic understanding of behavioural finance, one can put in place strategies to help mitigate the impact on investments.
Loss Aversion
A loss always appears larger than a gain of equal size. Loss aversion theory suggests investors have a greater inclination to avoid any risk that could cause a loss, rather than to acquire a similar gain. And it also explains why some investors sell their winners and hang onto their losers in the hope the share price will recover.
Tips for mitigating the bias:
- Checking your portfolio too often is a good way to lose money. It can lead to increased stress and impulsive, emotionally-charged behaviour, which in turn results in underperformance.
- Completing a risk tolerance questionnaire with an investment professional will help you analyse your willingness and ability to take risk to meet their financial goals and life events
- Having a longer time horizon will enable you to ride out periods of shorter-term volatility
Herd Mentality
You must be able to analyse and think independently. Groupthink fuels speculative bubbles. Avoid blindly following famous investors or trends seen in the media, otherwise you risk buying or selling too late as it is likely that the news is already priced in.
Tips for mitigating the bias:
- Create an objective investment strategy that spreads your risk across different sectors, countries and asset classes
- Carry out a wide range of research including some that opposes your investment case
- Include investments with different styles (growth, value, etc.) in your portfolio to help ensure it will perform well in a variety of market backdrops. A contrarian strategy can also be used to avoid this bias.
Anchoring bias
Historical share prices cannot predict the future. Overly relying on the first piece of information or share price estimate for a company can cloud an investor’s judgement. Any subsequent news or share price movements may be looked at differently as a result.
Tips for mitigating the bias:
- Pound cost averaging is a strategy for investing a cash lump sum in phases to smooth out short-term volatility. Investors will receive an average entry point which reduces the likelihood of buying in at the wrong price.
- Investing small amounts on a regular basis would also have a similar effect
Overconfidence
At times, investors can be overconfident in research they have or their ability to act on information in a timely manner to maximise profits. But markets move fast and as a retail trader, you are trading against institutional investors and even algorithms.
Tips for mitigating the bias:
- History shows that time in the markets is better than trying to time the markets. Usually some of the best days follow quickly after the worst. If you panic and sell investments that have fallen in value, you will crystallise your losses and risk missing any subsequent rebounds. Research has shown that missing the 10 best market days can more than half your long-term returns.
- Investing in a portfolio of 20+ expertly managed funds, instead of individual companies, would reduce risk and increase diversification
By Eilidh Anderson, Investment Manager
The above should not be relied or construed upon as advice. Past performance is not a guide to future returns.