When you consider your investing habits, you may not think that bias plays a significant role. After all, we all like to think that we’re rational and logical people, so why shouldn’t our investing habits be too?
No matter how clear-sighted we like to believe we are, we’re only human and liable to make decisions based on unconscious biases. Here are five of the most common ones and how they can impact your investing habits.
1. Confirmation bias
Confirmation bias is a very common subconscious bias and essentially involves making decisions based on pre-established assumptions. Since these ideas tend to be based on feelings rather than facts, it can mean that they are not entirely accurate.
A good way to understand this bias is with newspapers. You probably have a favourite paper, which is likely to align with your personal beliefs – if you’re politically left wing, you may read the Guardian, or if you’re right wing, you may prefer the Telegraph.
People have a natural tendency to look for information that supports the ideas and beliefs that they already hold. While this is mostly harmless when it comes to things like newspapers, it can have a significant impact on your investing strategy.
If you already have a pre-conceived belief that a particular asset, sector, or company will perform well, you may be subconsciously drawn to the information that validates your beliefs. In the same vein, you may also ignore evidence that goes against your beliefs, which can have serious financial consequences.
2. Hindsight bias
Another common bias is the tendency for people to consider past events to be predictable while future events are not. This is a dangerous bias as it prevents you from objectively analysing past decisions.
For example, you may be able to convince yourself that you knew an event, such as a market downturn, was going to happen long before it did.
The obvious problem with this bias is that it means that you’re unable to properly learn from the past, which can lead you to make riskier investments in the future.
3. Loss aversion
According to the idea of loss aversion, people tend to consider avoiding loss to be more important than achieving gains. Research suggests that people feel the pain of loss twice as strongly as the pleasure of gain, and this can skew your thinking.
When you make a gain, it’s easy to not give it much thought and move onto the next opportunity for profit. However, when you make a loss, it’s equally as easy to take it personally as a failure of judgement.
This can lead to poor decisions and an inconsistent investment strategy as subconsciously your aim becomes to simply avoid the stress of loss. This could mean you’re too risk-averse with your investments.
A good example of this kind of behaviour is not selling an asset that is making a loss, in the hope that it might gain in future. Even though this may be a bad financial decision, you can subconsciously justify it since it means you don’t have to confront the loss.
4. Regret aversion
In a similar vein is regret aversion bias, which can mean that you fail to take advantage of investing opportunities for fear that you’ll make the wrong decision. The reason for this is that by avoiding making a decision, you can avoid the regret that you’d feel by making the wrong one.
While worrying about the performance of your investments is natural, it shouldn’t paralyse you through anxiety.
This nervousness can significantly lower your risk tolerance and increase tendency towards herd mentality and only investing in assets that are popular. While this can give you a greater sense of confidence, it doesn’t necessarily mean that your choice of low-risk investments is right for you.
5. Trend chasing
Leading on from regret aversion bias is the risk of chasing trends in your investment strategy. As we often say, the past performance of assets is no guarantee of future success, but people with a tendency to chase trends ignore this advice.
An excellent example of this bias in action was the recent surge in GameStop’s trading price earlier this year. The price of the company’s shares exploded from $17 at the beginning of the year to around $483 only a month later.
This sudden rise caused many amateur investors to buy in, following the trend, but many lost significant amounts of money as the share price fell by as much as 90%.
When investing it’s important to remember that chasing favourable past returns isn’t always a recipe for success, especially when the present reality is different.
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The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.