Behavioural Finance took shape in the 1980s, before this point traditional finance dismissed investors’ psychology and the idea that biases can work against the investor, to make good investment decisions. In behavioural finance it has been said that investors do not think or behave rationally, they are driven by a number of emotions such as fear and greed (Shiller, 1999 #7).
Below are some cognitive and emotional biases to be aware of that seem to have the greatest impact on investment performance:
Loss Aversion
People generally feel a stronger impulse to avoid losses than to acquire equivalent gains. Psychologically, the possibility of a loss is on average twice as powerful a motivator as the possibility of making a gain of equal magnitude.
If an investor has had a number of losses, this may prevent an investor from taking on the level of volatility required to ensure portfolio growth over the long term. When there is a market downturn, those willing to put aside their emotions and invest while prices are low could reap the long-term benefits when markets recover.
Present Bias & Self-Control Bias
Present bias refers to people favouring immediate gratification while discounting their future preferences. Self-control bias is the behaviour tendency that causes people to fail to act in pursuit of their long-term, overarching goals due to a lack of self-discipline.
How many of us have said that we will start a healthy eating plan. However, if offered a treat we would accept it or if we wanted to eat a sweet snack, we tell ourselves “I will start my healthy eating on Monday.” Two years have now passed, and we have still not started our healthy eating plan. When held accountable for not starting on Monday, we may defend our actions by responding “I didn’t say which Monday.” This shows that we as humans value the instant gratification of eating that sugary sweet over our long-term well-being and long-term goal to be healthier and have no self-control.
This bias also exists in the financial decisions we make. We know that we should save, not only for retirement but for emergencies, nevertheless if we want to purchase something we tend to without hesitation. This reflects present bias and self-control bias; we may squander our pay cheques to purchase the non-essential items we want now with no regard for our future.
Investors that have present value bias may incur the following detrimental effects; may rush investment decisions, have the feeling of needing money now resulting in the sale of assets in poor market conditions and may not save enough funds for emergencies or their longer retirement (ING, 2019 #11).
This can affect investors by them spending more today rather than saving for tomorrow, this is a lack of willpower as the investors will tend to indulge in poor habits. Therefore, when they retire, they have insufficient capital to last them retirement (Sinha, 2020 #12).
Confirmation Bias
Confirmation bias is the tendency to seek information that confirms an existing theory. This can lead to overconfidence as the investor continues to obtain data that appears to confirm the decisions they have made. This can lead to a false sense of security (Douglass, 2019 #1).
This is detrimental as investors tend to filter out and ignore facts that refute them, by doing this they are missing potential useful facts and information that is needed when making financial decisions (Scott, 2021 #10).
Overconfidence Bias
People who have overconfidence bias, believe that they are better or more educated on a topic than they really are. We all know there isn’t a crystal ball when it comes to investing and it is hard to know with certainty which way the stock market will go. Overconfidence impacts our ability to make sound investment decisions based on the facts at hand.
Anchoring Bias
Anchoring bias refers to the tenancy to ‘anchor’ to a piece of information when making a decision. Even if, presented with new information the investor will ignore it or react slowly. Anchoring is also used when making an estimate, we will use a benchmark and adjust up or down from this, the benchmark can be considered an anchor (Zaiane, 2015 #9).
This can be detrimental as investors can make rash and incorrect financial decisions as they may sell overvalued investments or purchase undervalued investments. Investors may hold investments as they are anchored on a price.
The status quo bias is when investors are provided with a large number of options that are complex and can be confusing, they will opt to remain in their current investment (Samuelson, 1988 #13). As investors are sceptical when it comes to change, they are more than likely to stick with what they know (Juneja, 2015 #4).
Status quo can have serious impacts on investors, as they may not take advantage of investment savings opportunities and rather than taking a risk for the potential to improve their financial position, they remain unchanged (Cherry, 2020 #15).
How to combat the impact of our biases
These biases cannot be eliminated because they are human nature. Investors can, however, be aware that they exist and slow down their thinking when making important financial decisions to help them stay on track and improve their rational decision-making process.
One strategy that could be implemented is to ensure that you have a strategic asset allocation, this is designed to meet your long-term objectives with your individual needs in mind. Instead of letting our biases take over, the investments within our portfolio are rebalanced back to the set allocation when certain asset classes perform either positively or negatively. The result is that investments are sold at the top and purchased when they are ‘cheap’ – the gamble is removed. The asset allocation is in place to protect us from ourselves and our biases.
Another strategy is to speak with your adviser to ensure that you do not deviate from your financial plan. Your plan takes into consideration your goals, return expectations and needs, and risk profile. Your financial plan is an individualised, long-term strategy meant to withstand multiple market cycles. If you have the urge to change your plan during a market correction, pick up the phone and discuss it with your adviser as this will help reduce any reactionary emotions and shift your mindset back to the big picture.
Caitlyn Kent (DipFP, BCom(Acc)) Associate Adviser of Alman Partners Pty Ltd.
Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.
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SINHA, A. K. 2020. The Effect of Behavioral Biases on Retirement Planning.
ZAIANE, S. 2015. Behavioral biases of individual investors: the effect of anchoring. Eurasian Journal of Social Sciences, 3, 13-19.