The impact of these behavioural biases has been widely documented throughout academic and scientific studies1. Here, we outline some of the most common biases that cloud our judgment, leading us to take mental shortcuts that ultimately result in less optimal financial decisions.
Overconfidence
Overconfidence, often considered one of the most destructive human biases, leads investors to believe that they know more than they actually do, prompting them to act on this misguided certainty. One common example of this is excessive trading, where individuals trade more frequently than is advisable, often at a significant cost, due to their confidence in their ability to time the market. This assumption is usually flawed, as we explore in more detail here.
Loss aversion
Closely related to "regret aversion," this bias can prevent us from making decisions that might lead to a perceived loss. According to Daniel Kahneman and Amos Tversky's (1979) Prospect Theory, “losses loom larger than gains,” meaning that the pain of losing is psychologically more impactful than the pleasure of an equivalent gain.
This tendency often makes us reluctant to acknowledge a poor decision, which may explain why investors are slow to sell a failing asset or to reverse a questionable investment strategy. Loss aversion can keep us locked into unwise choices, fearing the regret of admitting a loss more than the actual loss itself.
Availability bias
When making a decision we are often persuaded by information which is readily available or which is familiar to us. If it’s in the news or we can recall it easily then we deem it to be important.
The implications for investing can be profound: people may invest in a prominent company (perhaps with a powerful command of how to leverage publicity) without assessing whether the actual fundamentals (sales, profits, balance sheet strength) are sound.
Availability bias also helps to explain why we may make a decision based on a singular economic event or news release (such as a lower interest rate projection, or businesses bouncing back after the pandemic) when a more considered or long-term view may be more prudent.
Herd behaviour
It is not unusual to follow the herd – we find safety in numbers. Yet the crowd is not always right, nor wise, so blindly copying the actions of the many can lead us into financial trouble. Wildly popular stocks and the fear of missing out can frequently mean our money is taken for a ride if we don’t pause to ask the right questions.
The dangers of herd behaviour are well-documented, from the Dutch tulip mania of the 17th century to the dot-com bubble and more recently the hype around meme stocks and NFTs. These examples show us how the costs of following a crowd can be persistent – and sometimes costly.
Confirmation bias
First impressions count, but we shouldn’t always rely on them. Confirmation bias means that we are more likely to take notice of information that reinforces our beliefs and outlook –while overlooking contradictory evidence.
This behaviour prevents us from exploring opportunities which may be to our benefit, as we tend to look for information that supports how we already think. For example, we might believe that active fund management is a price worth paying, even if the facts show this is rarely the case, in both strong and weak markets. This bias can keep us locked into less optimal decisions simply because they confirm our preconceptions.
Status quo bias
We often gravitate toward the path of least resistance, preferring to keep things as they are. This tendency can arise from a lack of information or uncertainty about making a change, leading us to stick with the familiar. Any deviation from the status quo is often perceived emotionally as a loss, which can explain our inertia and reluctance to make adjustments, even when change might be beneficial.
This inaction often affects our finances – for example, if we leave money uninvested even as interest rates fall or persist with investments that charge high fees.
Taking stock of these biases
Being aware of these biases doesn’t prevent them from taking hold or producing conflicting messages – we may be overconfident on one hand, while also suffering from the paralysis of inertia. But their effects may be mitigated with a little insight into how they assail our emotions and derail our reasoning.
A way to overcome any biases is to look at information objectively – and to try and assess the difference to our wealth that taking an action, or not acting at all, will make.
We may also reduce the impact of our cognitive and emotional shortcomings by choosing a wealth manager to diminish their grip on our senses. At Netwealth, our investment professionals have a wealth of experience in handling the biases that individual investors typically face as we build efficient, diversified portfolios with a long-term strategic outlook in mind.
Get in touch to find out more about how we can help you.
Please note, the value of your investments can go down as well as up.
1 These include Prospect Theory, the Disposition Effect and Nudge Theory.
