Investors would be surprised to hear that they themselves might be the biggest threat to their own investment returns. This is because emotional and cognitive biases affect our decision making.
Investing is simple but not easy. Most of the times you need to analyse and effectively understand a lot of information, and even make decisions based on inadequate information.
In order to shorten the analysis time when making decisions, the brain uses emotional filters and shortcuts to process and analyse information. This results in people making irrational and biased decision which can lead to bad investment returns.
Below are some of the most important biases to look out for when making investment decisions:
This is when you place too much confidence in your own abilities. Put simply, it is the illusion of knowledge.
The result is that people underestimate risk and overestimate their knowledge and ability to predict and control events. This leads to excessive trading, risk taking and poor trading decisions.
Investors usually exhibit overconfidence after a period of success. So, beware of this bias after you had a good run of choices, forecast or trades.
2. Loss aversion and regret
Regret is an emotional pain that people feel when realising that a decision they made was the wrong one. People naturally seek actions that cause pride and ignore ones that lead to regret.
The fear of regret causes investors to hold on to losers too long and sell winners too early. Instead of selling the loser and using the money to invest in something better, you hold on to the share with the hope that it will at least break even and in the process, you avoid the feeling of regret.
3. Confirmation bias
This occurs when investors make a certain investment choice or have a specific idea, and then look for information that supports this decision and ignore information that opposes this decision or idea.
This creates a one-sided view of the situation, resulting in bad buying and selling decisions.
This is when people make decisions based on a past reference or a small piece of information. Anchoring biases can cause investors to buy or sell shares because they have gone up or down in comparison to their previous share price - instead of basing their decision on thorough analysis.
Although the biases mentioned are just a few of many, being aware of them is the first step in limiting the effect on your investment decisions.
Nevertheless, the fact of being aware of these biases is not a guarantee that you will be able to prevent them when making decisions.
Steps to take to avoid the bias trap
But there are some steps you can take to minimise the effect of these biases on your investment decisions. These include the following:
- Understand your biases: Know the biases and how they affect your decision-making.
- Know why you are investing: What is your investment goal?
- Have some quantitative investment criteria: This will prevent you from investing based on what is happening in the market, emotion, psychological biases and rumours.
- Diversify your holdings: Don’t put all your eggs in one basket, just because you have a high conviction.
Investors are influenced differently by these cognitive and emotional biases. So, as an investor it is important for you to have a certain level of self-knowledge.
Identify your weaknesses and use the steps above to improve your overall ability to make better investment decisions, which will hopefully result in higher returns.
- Werner Erasmus is the Gauteng regional manager of Overberg Asset Management.