Behavioural Bias- How Are You Affecting Your Investments?
As investors, we’re all human. All individuals with our own characteristics, attitudes, beliefs and behavioural patterns. These different aspects affect our actions in day to day life in many ways to varying degrees. So why would we disregard ourselves as individuals when it comes to our behaviour in the investment market? The short answer is, we shouldn’t.
This belief has been reiterated lately in a report from Schroeders titled ‘The Bias of UK Investors That Could Lead to Lower Returns’. Over 23,000 investors have taken the Schroeders investIQ test with the aim of understanding these behavioural biases and how they affect investment actions and returns.
It was found that UK investors were most likely to suffer from what is known as ‘Ambiguity Aversion’. However, just because this is the most frequently occurring of the behavioural biases in the UK, doesn’t mean that we as investors should focus solely on controlling one behavioural bias. Each investor is human, and as humans we each have a unique combination of behavioural biases which make us individuals.
In a time when people are free to express themselves as individuals more than ever, psychology and a tailored appreciation of a person’s personality have become second nature. It is appropriate that this attitude is transferred into the world of investment. Below are the biases as listed by Schroeder:
Herd Bias: As humans we can be influenced by the thoughts and behaviours of those around us (The Herd). We tend to assume that the herd collectively knows something we don’t. As a result, we irrationally follow others, ignoring the information we have and what’s right for us as individuals.
Over Confidence: Overconfidence is the tendency to believe in yourself without considering factors beyond your control. This may lead you to overestimate your ability to make rational investment decisions. As a result, you might think investment markets cannot surprise you, you might take on more risk than necessary, and move investments around too frequently.
Ambiguity Aversion: Investors with ambiguity aversion tend to choose investments that will provide them with more of a known possible outcome over ones that are more uncertain. This could lead to investors taking less risk, which might lead to lower potential returns. However, taking on more risk is subject to greater losses.
Loss Aversion: Investors with loss aversion bias tend to feel losses more sharply than the equivalent gains. This can impact our ability to make rational decisions and we end up trying to avoid losses at all costs rather than logically considering the alternatives.
Projection: This is the tendency to believe that your current views, feelings and needs will stay the same over time although statistically this is highly unlikely.
Over Optimism: This is the tendency to overestimate the likelihood of success without focussing on any potential pitfalls. In investment terms, you may be too focussed on the positive potential outcomes and not realistically consider the possibility of incurring losses. As a result, you may take on more risk than you can sustain.
Anxiety: This is when you tend to be easily influenced by the short-term ups and downs of the market and feel compelled to take action. This may lead to irrational investment decisions that undermine your long-term financial objectives.
Regret Aversion: This is the fear that your decision will turn out to be wrong in hindsight. Your anticipation of feeling regret rules the choices you make and even when you’ve made a choice, you can still feel uncomfortable and you continue to dwell on your decision. The worry of not getting it right can also lead you to avoid taking any action altogether. In you desire to avoid regret, you may be tempted to follow the crowd, even if what others are doing isn’t appropriate to your circumstances. You believe that if things go wrong, you will have less regret if others have done the same.
Impulsivity: This is the tendency to focus on the here and now rather than the future and favour immediate rewards rather than future ones. For example, given the choice between receiving £100 today, or £120 in two weeks’ time, you would choose to have the money today. As a result, you can overvalue immediate rewards to the detriment of your long-term goals. In financial terms, this means you could find it difficult to change your short-term spending habits, in order to save sufficiently for the future.
Awareness of Behavioural Bias can now more than ever help us understand our clients as people. We can better manage and coach our clients to balance and control each of these behaviours and not allow them to affect investment performance. The overall goal is that investors feel fully satisfied that they have acted without unnecessary psychological hinderance and have maximised investment performance based on logical financial objectives.