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Making smarter investment decisions is something we all strive for. We like to think that we’re logical, that our decisions are grounded in reason and not emotion. But let’s face it – we’re only human, and our brains have developed shortcuts to help us navigate a complex world. These shortcuts, or biases, mean that our personal beliefs, past experiences, and even our instincts can influence our investment decisions.
The good news is that we can learn to recognize and counteract these biases to make better investment choices. Understanding where these biases come from is the first step.
Our Instincts and Biases
From an evolutionary standpoint, our biases are a survival mechanism. Our ancestors relied on quick, instinctive decisions to avoid danger – like a sabre-toothed tiger lurking in the bushes. Today, we’re not dodging predators, but we still react instinctively to perceived threats, like market volatility.
Investing isn’t a life-or-death situation, though it can feel that way when it’s your hard-earned money on the line. Recognizing that we don’t need to make split-second decisions can help us respond more calmly to market ups and downs.
Types of Biases
Biases come in two flavors:
- Emotional biases – These come from our feelings – fear, greed, regret – and can lead to irrational decisions.
- Cognitive errors – These stem from how we process and remember information.
While emotional biases are tough to shake because they’re tied to our feelings, cognitive biases are a bit easier to address because they’re more about logic and reasoning.
Common Cognitive Biases
- Overconfidence: Believing we know more than we do.
- Confirmation: Focusing on information that confirms our beliefs.
- Anchoring: Relying too heavily on the first piece of information we see.
- Loss aversion: Fearing losses more than valuing gains.
- Herding: Following the crowd.
- Recency: Giving too much weight to recent events.
These biases have deep evolutionary roots and were once helpful for survival. For example, loss aversion might stop us from realizing our mistakes in the stock market, leading us to hold onto losing investments. Similarly, herding behaviour was once about sticking with the group for safety, but now it can lead to panic selling or buying into a bubble.
How to Manage Your Biases
To manage these biases, develop self-awareness and adopt a systematic approach to decision-making. Research, analysis, and diverse perspectives can help. Here are some strategies:
- Keeping an Investment Personal Statement – this is a document that you covers your Financial Plan reflective of your values. The Financial Plan could comprise: Asset allocation, Emergency funds, Debt, Spending, Insurance etc.
As this written plan is based on your values and risk appetite this will ride you through the vagaries of the markets
- Taking a Pause – Take a moment before making an investment decision. Collect information and think it through (refer to the Investment Personal Statement). Sometimes the best action is inaction.
- Automate – SIP are an investors friend for a reason. When there is no decision to be made, there are no biases to be encountered.
- Devil’s Advocate – Have someone you trust challenge your investment logic. A good devil’s advocate is logical, honest, and invested in helping you make sound decisions.
Investing doesn’t have to be a wild ride. By understanding and managing your biases, you can make decisions that align with your goals and lead to better investment outcomes. Remember, when in doubt, consult a professional who can provide guidance tailored to your unique situation.
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