It is easy to assume that we all make purely logical decisions, based on the best information available to us at the time. However, studies show that even the best-informed of us suffer from ‘thinking mistakes’, known as cognitive biases.
When we are investing, these biases are important because they can affect whether we buy, hold or sell an investment at the right time, as well as whether we invest at all.
Knowledge is power when it comes to investment biases, so asking yourself when making financial decisions whether you are falling prey to any of these might lead to better outcomes.
1. Loss aversion
A pound is a pound, so technically we should feel equally as happy when our investments gain a certain amount as we feel depressed when they lose the same. Not so, says science, with experts stating that we feel roughly twice as bad about losing money as the amount of pleasure we feel when we gain it.
Why is this important? Because it can affect whether we invest or not when we remember how bad it feels if an investment goes down in value, forgetting that, in many cases, we may gain more than we lose. We may be tempted to ‘play it safe’ even if, over time, taking more investment risk might be a wiser strategy.
2. Social Proof
We all know it can be easy to follow a crowd, and social proof is an example of just that. If lots of people are doing the same thing, we assume that they know what they are doing and go along with doing the same.
The best-known social proof experiment was carried out by Muzafer Sherif in 1935, when he put people in a dark room and showed them a dot that appeared to be moving to different degrees to different individuals, due to an optical effect. In reality, the dot was not moving at all, but when participants were asked to estimate how much it moved, they deferred to group estimates rather than their own experience, illustrating a tendency to trust ‘the herd’.
If we do this with investments, we risk rushing into commitments that we do not understand or are not suitable for our needs.
3. Confirmation bias
One of the best-known biases, confirmation bias involves us all seeking out and recalling information in a way that confirms or supports our existing values and beliefs. This means that when we research around a subject, such as an investment, it is easy to strengthen the beliefs we already have rather than challenging them with new information.
This is particularly the case nowadays, with social media, which often only shows us those articles and points of view we are likely to agree with. It is a problem when we are investing, as it stops us seeing all possible angles when deciding whether to buy or sell a stock or fund.
4. The Disposition Effect
The disposition effect is particularly relevant to investing and refers to our reluctance to sell assets that have made losses, instead focusing on selling assets that have made gains.
In some cases, this may be the wrong decision, as we hold on to assets that are losing value in the hope that eventually we will not have to crystallise our losses after all, but sell out too soon on other investments.
5. Anchoring Bias
Anchoring bias comes in when we rely heavily on one piece of information, or ‘anchor’ when making decisions about another. So, for example, if you were looking to buy a computer and the first one you see is £5000, a computer priced at £1000 may look cheap. However, the £5000 price tag is irrelevant to the price of the second computer.
Similarly, when you are buying an investment now that was at a particular price three months ago, you might conclude it is cheap or dear depending on its valuation relative to that earlier price. In reality, though, the ‘anchor’ that was the investment’s price three months ago has little bearing on its worth now.