As Investors, it is important to be aware of our own biases that impact our decisions when we invest in order to limit them and therefore make more cognitive decisions to ultimately better your situation. And it is even more imperative for financial advisers to acutely be aware of their own behavioural biases to make them better decision makers and money managers which in turn fosters a better client-advisor relationship.
The study of behavioural finance is quickly gaining tractional in recent years, as the identified divergence between observed actions and what is theoretically optimal becomes more and more evident. Behavioural Finance aims to describe how investors and markets actually behave in practice, rather than the theory outlined in neat easy-to-explain models. These ‘perfect’ theories that behavioural finance aim to debunk are all based on this the economic term known as ‘Rational Economic Men or REMs’ – but as we all know investing far from rational at times when it’s your hard-earned money at risk and can even seem like a roulette table at times.
Effectively understanding how people make decisions; both individually and collectively can offer a significant advantage in the equity markets – or for any situation for that matter. Therefore, it may be possible adapt behaviours to improve economic outcomes.
Decision making and biases as investors and advisers can be categorised into a few key areas;
As much as most of us would hate to admit it, we all have the tendency to overestimate our own abilities, after all 80% of drivers think we are good drivers and yet accidents occur every day. This fallacy also spills over to equity investments, it can lead to not adequately diversifying investments – we all have them, those companies we REALLYYYY like, they’re our favourites, maybe they were the first stock we bought, whatever it may be, it causes investors to over allocate and subsequently take on more risk. Unfortunately, this is the same bias that is what makes it less likely for an investor to listen to an adviser – personally making my life harder when trying to lower their risk in the long run.
Luckily this bias can significantly be helped by; keeping yourself accountable to a third-party (e.g. a spouse or an adviser) as well as outlining and adhering to strict processes on the portfolio that are predetermined based on facts and correct theories.
Conversely, loss aversion is when an investor is debilitated due to a fear of losing money or ‘locking-in’ a loss. In fact, studies show that losses have twice the impact than a gain on an investor psychologically, and this can lead to an illogical decision making process. As an experienced Investment Adviser, I believe this one has the biggest impact on individuals when investing on their own, shrewd investors and money managers understand the concept of opportunity cost and know when to cut their losses.
A handy tip to counteract this difficult to manage bias is to not include entry prices on an investment so as to not be swayed by the profit or loss and look at the current situation completely objectively.
Diversification & Misuse of Information
Just as important as individual investment biases is broader strategy biases, investors can focus too much on the finer details of each company rather than the broader allocations of an investment portfolio. Investors must also be aware how they analyse the available information when they make assumptions based on past performance and the importance, they place on the information itself – known as Anchoring.
Lastly, and let me be clear that I believe this last point has the least impact overall but certainly an interesting one that highlights just how external factors can sway our thoughts process – known as Weather Watching. Put simply, even the weather outside has an impact on our investing decisions, the Case Western Reserve University deduced that even veteran investors were more likely buy stocks while the sun was out and were less likely to risk their money on cloudy days.
By being aware of our own behavioural biases and the theory behind them it is possible to manipulate them and skew them back in your favour and create a better economic outcome for yourself or your clients (as an adviser) through better investment decisions.