Behavioural finance is the study of how our emotions and inbuilt biases affect the decisions we make.
While we like to think that we are rational and governed by logic, this might not always be the case. We are all susceptible to letting our emotions play a part in decision-making and this can be particularly detrimental when it impacts investment choices.
Here are some ways you might allow emotions to govern the decisions you make, and how Hartsfield Planning can help you focus on the long term.
1. Loss aversion
Loss aversion is the human tendency to favour avoiding losses over acquiring equivalent gains. It is argued that the negative emotional impact of losing £100 is twice as strong as the positive effect that comes from gaining £100.
In terms of your investment portfolio, this might mean avoiding risk through fear of a future fall, or not selling poorly performing shares to avoid facing the reality of a loss.
Source: Economics Help
2. The “bandwagon effect”
The bandwagon effect, or herd mentality, could see you following the crowd. Investing in a company or sector because other people are doing it, rather than because it aligns with your profile and your portfolio’s “optimum” mix, could mean taking unnecessary risk.
Investors saw the negative impact of the bandwagon effect at the turn of the millennium when the dot-com bubble burst. More recently – as increasing numbers of investors turn to social media for their investment advice – the “Reddit Rebellion” saw short-sellers, and those who jumped on the bandwagon late, make significant losses on shares in US video game retailer GameStop.
It is important to remember that investing isn’t a competition with other investors to see who can make the biggest gains. It is about putting a long-term plan in place aligned with your goals and having the patience, resilience, and confidence to stick to that plan.
3. Anchoring bias
You might have suffered the effects of anchoring bias if you have previously made investment decisions based on a benchmark figure – such as a share price – that you have set yourself.
Although you might think your figure is based on sound judgement and rational logic, decisions made based on a potentially arbitrary figure could be bad ones. For example, you might hold onto losing stock in the hope that a future gain will see it arrive at the benchmark figure you set yourself.
4. Endowment effect
The endowment effect describes the human tendency to place a disproportionately high value on things we own – in this case, a share in a company – compared to something that we do not own.
In your investment portfolio, this could lead to a reluctance to sell. Selling could be the right decision, whether because a share is trading at a loss, or because it is necessary to rebalance your portfolio.
Breaking the emotional attachment and focusing on your long-term goals is key.
5. Familiarity bias
Diversification is a key component of how we spread your investment risk here at Hartsfield Planning.
While you might favour investment in a certain sector or geographical region that you know and understand well, familiarity bias could prevent you from diversifying your portfolio. Not only might you be missing out on opportunities in areas you are less familiar and comfortable with, but you also leave yourself open to the dangers of not spreading risk.
An unexpected fall in one area could have a disproportionately negative effect on your portfolio.
6. The choice paradox
A certain amount of choice can make you feel in control. Weighing up those choices, and selecting your preferred option, might even make you happy. But too much choice has the opposite effect.
An abundance of choice – in this case, an equity market filled with possibilities for investment – could leave you feeling stressed, worried about making the wrong choice, or unable to choose at all. This could lead to missed opportunities.
Get in touch
Hartsfield Planning can put together an investment portfolio that aligns with your risk profile, capacity for loss, and future goals.
Taking the time to step back can help you avoid knee-jerk decisions, making objective and informed decisions. But it isn’t easy. That’s why we are here to help.
Whether you need help managing an existing portfolio or are looking to invest for the first time, please get in touch and find out how our team of expert financial planners can help you.
The value of your investments (and any income from them) 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. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.