Investing Success: Becoming Conscious of our Unconscious Biases
Within the realm of financial management, ‘Behavioural Finance’ has become a fascinating area of research. Most of us believe we are fair and logically minded and that we make sensible, well-informed decisions. Problematically however, we all have behavioural predispositions which we are not consciously aware of; we all hold some biases.
Our genetics, upbringing, social relationships and physical surroundings are just a few examples of factors which influence our subconscious decision making. The fact that the logical parts of our brains don’t have complete control over our thought processes is a significant limitation when it comes to making financial decisions, however it is part of being human and without full intervention by Artificial Intelligence to automate our choices, the impact of biases is inevitable. The best we can hope for is to try and recognise our human limitations and develop strategies to mitigate their negative effects.
Confirmation Bias
We tend to seek out and read information which confirms our pre-existing beliefs and avoid or dismiss that which contradicts them. The investing landscape is rife with pundits predicting success for virtually any investment. If you are looking for an article promoting the virtues of big-tech, emerging market debt, oil and gas exploration or venture capital, you will have no problem finding one.
Affirmation that we are making the correct investment decisions makes us feel at ease and optimistic about the future. However, this optimism is built on flimsy foundations unless rigorous and impartial research is being undertaken. Importantly, information which is contrary to our current beliefs needs to be given equal weighting to that which is confirmatory. It is essential that there is a willingness to change in the face of conclusive evidence.
Recency Bias
We are ‘programmed’ to place more weight on recent events and experiences than historical ones. The main US stock market (measured by the S&P 500 index) has delivered annual returns of 13.6% over the last 10 years (1). Had you been invested in the US market over this period you would have seen fantastic returns on your investment, far greater than investing in any other major, national stock market index.
The problem here is a willingness to believe that this current run of performance will continue indefinitely and that an investment policy focusing purely on the US market will continue to make the best returns.
A cautionary tale of this risk of recency bias is to take a look back at the boom and bust of the Japanese stock market in the 1980s. Between Jan 1983- Jan 1990 the Nikkei 225 Index provided annual returns of 33.70%! (2) This was then followed by a market crash in which investors lost nearly two thirds of their investment value from the market peak in early 1990 to the trough of August 1992 (3). It took the Japanese stock market over 30 years to recover from its sudden – and for many, disastrous – devaluation.
Anchoring Bias
In investing, anchoring involves making a mental reference point of an asset’s value. This reference point will likely be the first (or highest) price we see, and should the asset decrease in value we are likely to feel that the asset is now priced too low. Imagine you have invested £1,000 in a small company share and within a week the value has dropped to £700. There may be a very good reason for this e.g. supply chain issues, lawsuits or poor cash flow management, but having anchored to the £1,000 price point you are unwilling to sell and cash-out at a price below what you have decided is the true value. There is a possibility of irrationally locking-in to an investment which may well continue to devalue, potentially dropping to £0.
Systematic Investing
Behavioural biases help explain market inefficiencies, like asset bubbles. But these inefficiencies are incredibly difficult to predict and exploit. We can however tackle our biases by adopting simple strategies to mitigate their effects:
Stick to a clear, defined investment strategy: Make sure you have an investment objective and strategy in place. This will help prevent you from making decisions to move between investment products on emotional gut feelings, despite a lack of robust evidence.
Diversify your investments: The boring but true “don’t put all your eggs in one basket (or even a few)” point. This reduces risk and therefore the likelihood of a panic induced response.
Avoid checking the short-term performance of your investments: Our brains seek patterns in data, and extrapolating future returns from short term price movements is financially very dangerous. Again, try to be confident in your long-term investment strategy and try to check in on your investment performance at set times each year.
Accept you don’t have perfect judgment: As informed and as intelligent as we can be, we can never become totally devoid of bias in our analyses and reasoning. Indeed, to believe that we do have near perfect judgement is just evidence of another bias: over-confidence.
At Collingbourne we provide our clients with evidence-based and impartial investment advice, protecting them from their and even our own cognitive biases. If you think you could benefit from help in developing an objective and systematic investment strategy, please do contact us and we can discuss whether we could be the right people to help.
All returns stated are Total Returns, dividends reinvested in GBP terms. Data sourced from Financial Express Analytics. Indices are not available for direct investment and take no account of charges or tax.
(1) 31/05/2013 – 31/05/2023 S&P 500 Index
(2) 14/01/1983 (earliest point available) – 01/01/1990 Nikkei 225 Index
(3) 01/01/1990 – 19/08/1992 Nikkei 225 Index
Disclaimer:
This document should not be considered a recommendation to purchase or sell any particular investment. Care has been taken to ensure the accuracy of content, but no responsibility is accepted for any errors or omissions. We do not predict or guarantee the future performance of any individual security, investment, portfolio or asset class.
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