Whilst we know that financial decisions should be based on logic, it’s easy for emotions and past experiences to creep in and cloud your judgement. Investment bias can mean you end up making decisions that aren’t right for you. Recognising that bias occurs is the first step to tackling it.
Evolution means that we often use emotions and experiences to make decisions. It allows us to make quick decisions that for our ancestors could have meant the difference between life and death. But when it comes to investing, a logical approach based on the fact, rather than a knee-jerk reaction, is a far better approach. It can be difficult to recognise when investment bias is affecting your judgement and there are many ways it could have an impact.
Have you ever been affected by investment bias? You may recognise these five behaviours when you look at your past decision-making process.
1. Confirmation bias
We often already form opinions on things before we’ve had a chance to delve into researching them. That’s normal but the challenge comes when you actively search for further information that already supports your beliefs. This is known as confirmation bias.
Rather than balancing differing detail to build an informed decision, you may place more emphasis on those that align with existing views. It can lead to you making poor investment decisions. Let’s say you believe an investment in a particular company will deliver returns but there are numerous sources of information with red flags. Rather than taking these into consideration, confirmation bias could lead to you ignoring them.
2. Loss aversion
Loss aversion refers to the tendency for people to feel more strongly about avoiding losses than obtaining gains. It can get in the way of investment success as all investments contain some level of risk and volatility within markets and this is to be expected. Loss aversion can stop you looking at the bigger picture.
In terms of investment, loss aversion can have an effect in many different ways. You may not pursue an investment that’s right for you because the perceived risk is too high. Similarly, you may refuse to sell a loss-making investment that’s no longer appropriate due to the losses, even if it could affect long-term finances.
3. Anchoring bias
We need to base investment decisions on something, but anchoring bias refers to investors that rely too heavily on past details. This could be the historic performance of a fund or share. Yet, we all know that past performance isn’t a reliable indicator for future performance. There are a whole host of factors that influence investment values, many of which will change.
As a result, focusing on past references can lead to investment decisions that are based on an out-dated perspective. Your investment portfolio should look to the future with a long-term view and be built with your goals in mind.
4. Familiarity bias
For some people, the familiar offers comfort and reassurance. It’s similar for investors too, with some gravitating towards well-known investments. It’s an investment bias that could lead to you taking too much or too little risk.
If you feel anxious about diversifying your portfolio or haven’t reflected on new circumstances in your investments, familiarity bias could be playing a role. A well-balanced portfolio is crucial for spreading risk in a way that reflects your personal goals. Stepping out of your investment comfort zone can be difficult but at times it’s necessary.
We’ve all heard of jumping on the bandwagon, and it’s something that happens in investing too. But making investment decisions based on what others are doing can lead to choices that aren’t right for you. Whilst a large number of people may be investing in a particular industry, their risk profile and aspirations may be drastically different from yours.
There can be some comfort in following the crowd that provides some validation in your decision. However, it’s important to remember that investment decisions are personal, what’s suitable for one person may not be appropriate for another.
How does financial advice help combat investment bias?
It can be hard to recognise when investment bias is having an impact on your decisions. It’s an area that financial advice can help with.
First, it gives you an opportunity to discuss investment decisions in the context of your financial situation and goals. Another pair of eyes and perspective can highlight where investment bias may be having an impact. As a result, it can help steer you away from the decisions that may not be right for you.
Second, a key part of financial planning is looking at the long term and giving you confidence in the future. Having a financial plan that’s tailored to you can curb the impulse to make changes based on bias. For example, if investment values fall your emotions may tell you to sell. But by sticking to your long-term financial plan, you’re likely to be in a better position when you look at the bigger picture.
Please contact us to discuss your investment portfolio and wider financial plan. We’re here to help you get the most out of your finances with your aspirations in mind.
Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.