The investment guru Benjamin Graham is quoted as saying the investor’s main problem, and even his worst enemy, is likely to be himself.
This was before the days of behavioural finance, but rings truer than ever.
As an investor, are you your own worst enemy by making irrational mistakes which you are most likely unaware of?
This question goes to the heart of behavioural finance, which combines the fields of psychology and finance in the decision-making process, says Victor Ricciardi, finance professor at Goucher College in Baltimore in the US and co-editor of the new book Financial Behavior: Players, Services, Products, and Markets.
Investors’ decisions are based on a collection of cognitive (mental) and emotional issues that can result in poor financial outcomes, says Ricciardi.
Gerda van der Linde, executive director of the South African Institute of Behavioural Finance, says investors are people and people make mistakes.
“It is therefore important to find out what mistakes you are prone to.”
Maarten Ackerman, chief economist and advisory partner at Citadel, says it is vital to know the biases that people have when making investment (and other) decisions.
If you understand them, you can avoid them, he explains.
“We are all human beings and we have certain preferences. It’s very important to understand how we think and how we view certain things.
How do we digest information and how do we let that influence us to make proper decisions and how does that apply to investments?” he says.
There are various money mistakes people tend to make, but some behavioural biases are encountered more than others.
1. Loss-aversion bias
This bias is due to someone’s intense fear of losing. Individuals assign more significance to a loss than to earning an equivalent gain and this is known as loss aversion, explains Ricciardi.
This emotional loss feels twice as painful on the downside as the same fixed gain on the upside.
These investors will typically hold on to losing investments too long and sell winning investments too early.
They therefore achieve the opposite of what they want and increase their risk, while lowering their returns.
2. Status quo or inertia bias
Ricciardi says some individuals suffer from status quo bias or inertia by defaulting to the same decision or accepting the current situation. This causes them to avoid many important financial decisions.
These individuals have the strong tendency or overwhelming impulse to focus on their short-term spending at the cost of avoiding saving or investing for the long term, according to Ricciardi.
People are inclined to overestimate their abilities and talent, which results in overtrading of financial securities and lower investment returns, says Ricciardi.
Over-optimism is something that investors need to guard against, says Ackerman.
“If they are over-optimistic or think they know more about something than the average person does, whether it is picking a fund manager or making an investment, the danger is that they will have so much conviction that they have a blind spot for the potential risks that exist, and they might not take the downside into account,” he explains.
Ackerman says to guard against being overly optimistic you need to look at your decision “from all sides and all angles and make sure there isn’t a risk that you hadn’t seen”.
4. Confirmation bias
This is the tendency to look for information that agrees with what you already think, says Ackerman. Investors look for things that support their decisions instead of looking at them objectively.
“This is also very dangerous in terms of making investment decisions,” he adds.
Individuals frequently place too much focus on the first information they process, such as the original price of a share, and consequently have difficulty adjusting their judgments to new information, says Ricciardi.
This is known as “anchoring”, where individuals will hold on to or anchor bad financial decisions of the past and will avoid future situations because they recall this negative experience.
Anchoring is when we use irrelevant, possibly even subliminal inputs in making decisions. In this instance, recent experience will influence your thoughts and decisions, says Ackerman.
How to avoid these mistakes
Ricciardi emphasises that people should learn more about finances.
“Learn about the value of portfolio diversification and investing for the long term, and especially the benefits of understanding different fund categories.”
He also advises investors to keep a journal. “Write about negative investment experiences and what causes your bad financial decisions.
This will hopefully help you avoid these repeated mistakes in the future.”
Lastly, his advice is to obtain the services of a financial professional: “Seek the advice of a financial planner to assess your overall financial health and to develop your short- to long-term goals.”
Niel Joubert is an award-winning financial journalist and recently completed his postgraduate diploma in financial planning from the University of the Free State.
Source: The South African Financial Planning Handbook 2017
This article originally appeared in the 18 January edition of finweek. Buy and download the magazine here.