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How behavioural biases affect investment decisions

How behavioural biases affect investment decisions

The Efficient Market Hypothesis (EMH) is an investment theory that states that current stock prices reflect all existing available information, making them fairly valued at any given time.

However, the reason long-term investors like Warren Buffett can consistently earn profits and outperform is because of market inefficiencies. These inefficiencies are inevitable because markets are composed of human beings, who no matter how disciplined, will often make financial decisions that consist of behavioural biases causing them to act on emotion.

On occasion, investors can be their own worst enemy and a limiting factor to successful investment returns. We can however seek to study and understand these common sources of error, and hopefully recognise when we are displaying some of these behaviours.

1. Fear and greed

Two of our most primal emotions can often govern decisions about whether or not to invest, or indeed to sell existing investments. Too frequently investors panic during market downturns and sell just before an upswing or hold off on an investment until the market has shown good returns, by which time they may have missed the best returns in that cycle. Overindulging in extreme amounts of either fear or greed can lead to unnecessary trading at inopportune times.

2. Framing

Nobel laureate Daniel Kahneman defines the effects of framing as follows: “Different ways of presenting the same information often evoke different emotions.” For example, he explains how consumers tend to prefer yoghurt labelled “99% fat-free” over those labelled “1% fat.” By narrowly framing the information (fat-free = good, fat = bad), we fail to consider all the facts as a whole.

3. Anchoring

Investors can base their decisions on irrelevant historical figures or statistics. For instance, when asked where you think X company’s stock will be in a year’s time? Most investors would first say “What is the price of X company’s stock today?”. Then, based on where the stock is today, they will make assumptions about where it’s going to be in a year. That’s a form of anchoring bias. We’re starting with a price today, and we’re building our sense of value based on that anchor.

4. Herd Mentality

Investors often rationalise a course of action based on the fact that others are doing the same – this is arguably the strongest trading bias. Humans have an extraordinary talent for detecting patterns and when they find them, they believe in their validity. When they find a pattern, they act on it but often that pattern is already priced in. Investors possessing this bias run the risk of buying into the market at highs.

5. Cognitive dissonance and confirmation bias

Cognitive dissonance relates to the mental discomfort that investors have to go through if they hold two conflicting views about the market in their minds. For example – an investor purchases X company’s stock believing that it will grow 15% per annum. However, over three years, that does not happen. Instead, Y company’s stock provides a 15% per annum return. In this situation, investors face mental discomfort. On the one hand, they may believe in the stock that they initially purchased whereas, on the other hand, they may want to liquidate the stock and buy Y company’s stock to achieve their immediate investment goals.

6. Gambler’s fallacy

If you visit a casino, you will often see gamblers recording the outcomes of the roulette wheel in the misplaced belief that this leaves them better informed of the next outcome. Whilst stock markets are not as random as roulette, there can still be a misconception that a share which has risen strongly cannot continue to rise.

7. Overconfidence

If you survey fund managers, you will find that most of them consider their performance to be above average. This is of course an oxymoron. Such overconfidence can come from a tendency for investors to credit their skills when an investment goes well but find mitigating circumstances for those investments which disappoint.

8. Recency bias

When considering factors, in an investment decision, it is common for investors to put too much weight on recent events. This occurs frequently when investors consider their attitude to risk; generally being more comfortable in taking on risk after a strong run in markets, but being risk averse after stock market downturns.

9. Loss aversion

Loss aversion refers to a phenomenon where a real or potential loss is perceived by individuals as psychologically more severe than an equivalent gain. For instance, the pain of losing £50 is often far greater than the joy gained in finding the same amount.

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Content on this page is provided for general information and is subject to change and does not constitute advice.
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