Volatile markets can tempt investors to follow their primal instincts and veer from their investment plans. Here are three typical investor behavioural traits to watch out for, and three ways to avoid falling prey to them.
We Homo sapiens have developed our brains over tens of thousands of years, and those brains are ideally designed to help us survive in what were very often hostile environments. For example, our instinct to fit in with “the tribe,” which was essential to our survival 15,000 years ago, today can lead to “group think.” This instinct works against us when investing, prompting us to blindly follow the “herd mentality” versus what is rational appropriate given our investment goals.
It’s not easy to control these deeply instinctive emotions that drive our behavior and form cognitive biases, or “blind spots.” Ninety-eight per cent of investors exhibit at least one behavioural bias.1 These biases can be helpful in our day-to-day lives, allowing us to use shortcuts and discern patterns that help us process information to make rapid decisions.2 However, these same biases can lead us astray when it comes to investing.
Here are three common cognitive biases2,3 to watch out for as an investor, and some ways to help correct for them:
1. Recency bias
Putting too much weight on recent experiences over historic ones. This “myopia” can lead investors to over- or under-estimate the probability of an outcome.
How to correct for it: Get the “big picture” – for example, look at the market’s performance over the last 20 years versus the last 20 months. Recognizing that markets and investments evolve given changing circumstances over time helps us maintain a long-term view, and encourages us to stick with our investment plans regardless of short-term volatility.
2. Loss aversion bias
Emotionally, humans suffer more from a loss than enjoy an equivalent gain. This can lead to prioritizing the avoidance of short-term losses over the potential for long-term investment gains. No one enjoys a loss, but short-term downturns in markets are an inevitable part of the investment journey. Losing sight of this can compromise your ability to achieve the risk-appropriate, long-term potential returns of investments such as equities.
How to correct for it: Ensure your investment plan aligns with your investment risk profile and capacity, and that the goals that underpin your plan truly reflect what matters to you. This can help keep you on track to your goals, and to prioritize the long term over the sometimes-unpleasant experiences generated by short-term volatility.
3. Familiarity bias
Investors are instinctively drawn to what is familiar to them, such as their own domestic equity market. This can lead them to overlook opportunities in foreign markets to diversify their portfolios – potentially enhancing returns and reducing risk.
How to correct for it: Review your asset mix to ensure you are properly diversified based on your investment risk profile. This can help overcome “home bias” and overly concentrated portfolios.
Talk to us about how we can help you avoid cognitive “blind spots” by building the right investment portfolio for you.
Sources:
1 "Who’s influenced by behavioural biases? Everyone.” Morningstar, 2021.
2 “How to avoid behavioural bias as an investor.” RBC Global Asset Management, 2021.
3 ”The Evolving Role of Behavioral Finance in 2020.” Cerulli Associates, 2020.
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