Biases are part of life, especially when it comes to investing. We may think we are making rational decisions, but when you look at the context and psychology behind our actions, it is very common for biases to creep in without us realising.
In this guide, we look at some of the common investor biases and some strategies you can use to avoid them.
Confirmation Bias
Confirmation bias is one of the most common behavioural biases in investing (and in life). It means that rather than objectively analysing the facts, you instead seek out evidence that supports your pre-existing beliefs and ignore anything that contradicts them.
An example of this would be deciding to buy a fund, and to back this up by looking for periods of positive performance while ignoring any negative factors.
How to Avoid It
Gather the evidence first, then make a decision based on all the facts.
Framing Bias
Framing bias means that sometimes the way information is presented can have more of an impact than the information itself. For example, a polished advertising feature might carry more weight for some people than a dry academic paper.
How to Avoid It
Look for multiple sources before making a decision. Consider where the information comes from and who benefits from it.
Overconfidence Bias
Many people overestimate their own skills and abilities. This can lead to assuming our decisions (and therefore the results) will be exceptional. This bias encourages many investors to believe that they can beat the market, even though this is statistically unlikely.
How to Avoid It
Look at the long-term statistics for active fund managers. While many beat the market over a short period, very few can sustain this over the long term. An individual investor is unlikely to fare any better.
Herding Bias
People rely on social proof and can be inclined to follow the crowd. This can mean buying investments because they are popular or heavily advertised rather than following the evidence.
Not only can this lead to unsuitable choices, but it can also artificially inflate the price of the investment, causing it to ‘crash’ later on when the price is corrected.
How to Avoid It
Remember, if your behaviour is average, your results will be too. Successful people usually stand out from the crowd.
Loss Aversion
If you lose £100, this can have a greater psychological impact than gaining £100. This can cause investors to be more proactive in terms of avoiding losses rather than seeking gains. An example would be selling investments during a downturn, even though the data tells us they will eventually recover.
How to Avoid It
Remember that ups and downs are part of investing. Make sure you have enough money to live on and a healthy cash buffer and you should be able to ride out short-term volatility.
Present Bias
This is a common bias which prioritises ‘now’ over the future, even when we know this won’t help us achieve our goals. This can lead us to put off investing or dip into our savings for instant gratification.
How to Avoid It
Start small, for example by saving for a few months to buy something you really want. Over time, you can incorporate more challenging goals. Automating your finances (e.g., setting up direct debits into your investments and savings accounts) can also help you keep your discipline.
Endowment Effect
This can lead us to overvalue something that we already own, even if the evidence tells us otherwise. For example, many people hold onto shares or older-style pension pots for many years, even when they could improve diversification or reduce costs by selecting something new.
How to Avoid It
Review your investments objectively, considering what else is available in the market. An adviser can help you with an impartial eye.
Disposition Effect
If we could consistently buy low and sell high, we would all make money easily. The disposition effect is based around this view. It means investors may sell better-performing investments (to take profit and avoid a drop) while hanging on to underperforming funds in the hope they recover.
How to Avoid It
Consider the bigger picture rather than looking at each investment individually. Do they complement each other and provide diversification? Regular rebalancing can also bring your investments back into line without constantly having to make decisions.
Probability Neglect
This means ignoring statistics and making counter-intuitive decisions in the hope of gaining exceptional results. In some ways this is the opposite of herding bias but can be equally harmful to your finances.
How to Avoid It
Follow the evidence and proven strategies. Take a long-term view rather than looking for quick wins.
Mental Accounting
Sometimes we can place a subjective value on money, depending on its source and what we plan to use it for. For example, we might be more careful with money we have worked for or inherited versus a cash windfall. This can lead to irrational decisions and financial inertia.
How to Avoid It
Try to think of money simply as a tool to spend, save, or invest depending on your goals. Making a plan can help you use your money in the most efficient way.
It can be difficult to take an objective view of money and avoid biases, even if you have managed your own investments for many years. It may be helpful to speak to one of our advisers for an impartial review of your investments.
Please don’t hesitate to contact a member of the team to find out more about the topics covered.
