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Avoiding Behavioural Biases When Investing

Written by Kris Wrenn

“I can calculate the motion of heavenly bodies, but not the madness of people”

Sir Isaac Newton, in reference to the South Sea share collapse in 1720.

Just as how we have an instinct to flee from danger or brace for an impact, falling markets can cause an instinctive response to sell shares and get away from a seemingly bad situation. The difference with share investing however is that the reality of the danger is often already incorporated into prices. It is best therefore to keep your emotions and biases under check when it comes to investment decisions.

There are many means by which behavourial biases can affect the way we handle our investments.

  • Having an affiliation with the product – this is perhaps more common in property investing where investors stick to the areas they are familiar with, justifying themselves by saying things like “I can keep an eye on it”. However the same can happen in share investing, with people being over-weight in an industry they are employed in, or a company they are a customer of.

Remain unbiased: remind yourself that better opportunities probably exist outside of what you have familiarity with.

  • Past experience / Hindsight Bias – It’s easy to look back on past performance at a stock or the market at large and convince yourself the outcome was predictable. When it comes to the market, this might be looking at a previous high and saying to yourself “of course it had to fall”. This is human nature in that it is our minds trying to create order. The reality is that no one can predict the market with success every time. Likewise with a particular stock, a previous bad outcome in a certain industry or asset class can affect an investor’s willingness to invest there again.

Remain unbiased: Remind yourself that a past failure does not mean a future one is inevitable. Similarly, a good past experience may be giving you a degree of overconfidence. Don’t be influenced by past regrets. It is possible to make a good decision and get a bad outcome!

  • Finding a reason – if we have biases such as those above, human instinct can cause us to look for supporting facts to reinforce it.

Remain unbiased: Step back and look at the whole picture. Spend as much time seeking a reason not to make a decision, as you do trying to reinforce it.

  • The Media! It goes without saying that the main aim of any provider of the news is to sell the news. They have an incentive to make current events sound more earth shattering than they really are.

Remain unbiased: Remember that although the news is “new”, it is not as current as the share market prices at any given time, i.e. whatever you are reading has probably already been factored in.

  • The disposition effect. Many years ago two academics Shefrin & Statmen wrote a paper regarding how investors instinctively SELL stocks that have made a gain and HOLD stocks that have made a loss. As a result of this, an investor will often lose out on an asset that continues to rise after they sell, and likewise hold on to a stock that may never return to a previous value. The inclination to sell a good stock comes from wanting to lock in a gain and validate their decision. The inclination to hold bad stocks can be stubbornness but it can also often stem from investors wanting to validate their previous decision to have bought it.

Remain unbiased. If you sell your rising stocks and keep your flat/falling ones eventually you will have nothing but underperforming stocks! I am not saying you should always hold stocks that have gained and always sell those that have lost, as always, I am saying you should look to the fundamentals of the stock/market, not to the history. Don’t justify a bad stock by saying “it’s only a loss if you sell”. Although technically true, there is still an opportunity cost given you could be invested in something else. In summary, don’t be more tempted to realise a gain than to realise a loss.

“Be fearful when others are greedy and greedy when others are fearful”

Warren Buffet. 2007.

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