Behavioural finance is the study of human behaviour and psychology on investors’ decision makings. Famous behavioural finance gurus include Nobel Laureates: Richard Thaler (author of “Misbehaving”), Robert Shiller (author of “Irrational Exuberance”), and Daniel Kahneman (author of “Thinking, Fast and Slow”). Included in the study of behavioural finance are the biases that investors hold when faced with an investment decision. These biases do not correlate with one’s levels of education or market experiences. Rather, it is suspected that people are affected by different psychological, cognitive, cultural and social factors. In all, understanding these biases can help us avoid some common investment mistakes.
Some of the common behavioural biases are:
- Price/Market Anchoring – This bias can prevent investors from ever selling unless the price of the investment gets back to their original purchase price, also known as their anchor point. Instead of taking a loss and investing the proceeds in something else that may have greater growth potential, we are permanently anchored to our personal reference point. Investors may incorrectly ascribe that price as the “justifiable” business valuation or the “reasonable” price to get out of a losing position.
- Familiarity Bias – this is related to “Home Bias”. For example, as Canadians, we are more familiar with Canadian companies. Canadians tend to not diversify into other countries, and we buy mostly Canadian stocks (e.g. banks). This will greatly limit the opportunities we have when it comes to investing, especially when the Canadian market represents only 3% of the global market.
- Confirmation Bias – this is the tendency to look for information that supports our previous beliefs and ignore any information that is inconsistent with our beliefs. Often this could lead investors to make the same mistake, to be unwilling to part with a losing investment, or to be unwilling to accept new information.
- Loss Aversion – most people have the tendency to be risk-averse because our tendency is to prefer avoiding losses rather than to generate earnings. That means the pain of losing $100 is more powerful than the joy of gaining $100. In this current ultra-low interest rate environment, this behaviour leads some people to prefer investing in GIC’s that pay close to 0% than to invest their money in a dividend-paying stock or a balanced income fund that pays 4% in income with further growth potential.
- Regret Aversion – this is the pain of feeling regret for making a wrong decision. An investor may regret a past investment experience that they have become so traumatized and vow to never invest in the market again. The past 12 years have been named “the most hated bull market”, potentially because some investors have been sitting on the sidelines and have watched the market go higher without participating in it. Ironically, sometimes the regret aversion bias can lead to investors regretting that they never participated.
- Hindsight Bias (knew-it-all-along phenomenon) – this is the tendency for people to believe, after an event has already occurred, that they had predicted it with a high degree of certainty. People that exhibit hindsight bias can sometimes make predictions of a market crash. The truth is if they make that prediction often enough, they will eventually be right as market corrections are inherently part of the stock market!
I believe knowing our biases will make us better investors. How? We can try the following strategies:
- Diversification – not putting all our eggs in one basket will greatly mitigate the risks associated with an individual stock/company/country
- Balanced portfolio – having a good asset mix of stocks and bonds will help smooth out the wild ride that comes with the stock market
- Dollar Cost Averaging – putting money systematically/periodically into our investment accounts will take away some of the fears/regrets that are associated with timing the market
- Seek help from an experienced investment advisor – investing on your own is not for everyone, so one should consider seeking professional help. A trusted and experienced advisor can provide the necessary guidance and help you in your life-long journey of investing!