Behavioural biases article for DIY investors

According to behavioural economics, the “real you” varies with time and context. Your environment, the information you have on hand, and even your mood are constantly in motion. These factors can combine to bias our decision-making processes, which can cause havoc when it comes to financial planning.

What are behavioural biases?

We all act based on mental rules of thumb. This is because of a biological need for efficiency. Our brains very quickly sum up information to make decisions in a fast-moving world where we never have all the information.

You may have done this many times today already. If you drove to work this morning, you made use of behavioural biases. Perhaps it was adjusting your route based on traffic. You won’t have had time to dwell on that and gather a complete set of information. Your brain used a kind of rule of thumb.

These shortcuts can be useful in the right circumstances. You don’t want to pause and think too hard when a tree falls on the road in front of you. However, for investors, shortcuts also pose risks.

These mental reflexes can lead to bad investment decisions. Your emotions, the latest viral video you watched, and even the order in which information is presented can all lead you to make rash or skewed decisions that could derail your investment plan.

What are bad behavioural biases when it comes to investment?

• Loss aversion is a big one for investors. We tend to overemphasise losses, which can cause us to sell investments too soon. But selling at the first sign of a downturn is a poor strategy. As we often say, time in the market is better than timing the market.
• Herding is another one that refers to our need to be part of a group. It is a human survival mechanism. We are all better off when we cooperate. However, following the herd is not an investment strategy.

This is a particular risk in an age of social media and meme stocks, or equities that swing dramatically based on the latest social media trend or influencer post. Just think of GameStop. The share price rocketed and then dropped catastrophically during 2021 based not on changes in the business’s fundamentals, but on a sort of social media mania. Yes, a few investors were lucky during this phenomenon. But luck is not a strategy.

• Present bias refers to our tendency to fixate on the here and now. But we aren’t investing for the here and now. We are doing it for our future selves. As behavioural economists have demonstrated, the “me” of the here and now is not the same person as “future me”, who will benefit from good investments when I retire many years from now. Present bias can encourage decisions that are good for current me and bad for future me.
• Choice overload is very much a modern phenomenon we experience in all areas of life. Our parents and their parents had limited choices when it came to saving for retirement. Today, we can invest internationally with the click of a button, and there are ways to invest in everything from solar farms to a fraction of a farm. Information comes from a never-ending array of sources, including social media influencers. We see this in the financial behaviour of young people. They have less trust in traditional financial advisors and more interest in alternative investments.

Beating your biases when making investment decisions

Biases are hard-wired into us, and we often aren’t aware of them, which makes overcoming them a challenge. Fortunately, there are ways to get the better of them.

• Goals-based investing can not only protect us from our biases, but harness them. Simply saving for some vague purpose is okay, but we can use the power of our emotions if we’re explicit about our goals. Studies show that if we think about our specific goals – like a holiday or new home – and the people who will benefit from the investment – often our children – we can nudge ourselves into saving more wisely.

Richard Thaler and Cass Sunstein call this reframing of decisions “choice architecture”. They have shown how commitment devices help us overcome the present bias in particular. We can limit the opportunities for our mood to change our saving habits by locking in a decision. One example is committing to putting some proportion of an upcoming bonus into a designated investment. Making that decision now means we aren’t tempted when the money arrives.

• Having a good relationship with your advisor is also a line of defence against bad biases. It is important that your advisor not only understands the array of biases that impact investing, but that they can spot them and guide you accordingly. This requires you to be open and honest with your advisor. We usually approach our advisors when emotions are heightened. It may be when changing jobs, having a baby, or during a time of financial distress. This makes you even more prone to following biases than usual.

This is critical when faced with choices and information overload. Individual investors simply don’t have time to evaluate the full spectrum of options and endless information about them. That is what a good financial advisor does.

• “Un-trick” your brain. There are some simple hacks for this. Here is a favourite of mine: sleep on it. Before making any financial decision – especially if it marks a change from your existing strategy – give it 24 hours. This will move you from making an instant, emotion-driven decision to slowing down and making a more logical decision.

How can 1nvest help? We provide the tools for the “you” of today to build a portfolio that maximally benefits the “you” of the future. Our funds track major indices and benefit from extended spells in the market. This means our clients see the best results by buying and holding assets as part of a predetermined strategy – ideally constructed with a financial advisor – without constantly evaluating their positions. This helps to avoid bias creeping in.

See our full array of products, or speak to your financial advisor about using 1nvest index-tracking products to beat your biases and achieve your financial goals.