Behavioural biases in investing – An introduction
Your own behavioural biases in investing are often the greatest threat to your financial well-being. As investors, we leap before we look. We stay when we should go. We cringe at the very risks that are expected to generate our greatest rewards. All the while, we rush into nearly every move, only to fret and regret them long after the deed is done.
Why do we have behavioural biases?
Most of the behavioural biases which influence your investment decisions come from myriad mental shortcuts we depend on to think more efficiently and act more effectively in our busy lives.
Usually (but not always!) these short-cuts work well for us. They can be powerful allies when we encounter physical threats that demand reflexive reaction, or even when we’re simply trying to stay afloat in the rushing roar of deliberations and decisions we face every day.
What do they do to us?
Those same survival-driven instincts that are otherwise so helpful can turn deadly in investing. They overlap with one another, gang up on us, confuse us and contribute to multiple levels of damage done.
Friend or foe, behavioural biases are a formidable force. Even once you know they’re there, you’ll probably still experience them. It’s what your brain does with the chemically induced instincts that fire off in your head long before your higher functions kick in. They trick us into wallowing in what financial author and neurologist William J. Bernstein, MD, PhD, describes as a “Petrie dish of financially pathologic behaviour,” including:
- Counterproductive trading – incurring more trading expenses than are necessary, buying when prices are high and selling when they’re low.
- Excessive risk-taking – rejecting the “risk insurance” that global diversification provides, instead over-concentrating in recent winners and abandoning recent losers.
- Favouring emotions over evidence – disregarding decades of evidence-based advice on investment best practices.
What can we do about them?
In this multi-part look at of behavioural biases,” we’ll offer an introduction to investors’ most damaging behavioural biases, so you can more readily recognise and defend against them the next time they’re happening to you.
Here are two additional ways you can defend against the behaviourally biased enemy within:
- Anchor your investing in a solid plan – By anchoring your investing decisions in a carefully constructed plan (with predetermined asset allocations that reflect your personal goals and risk tolerances), you’ll stand a much better chance of overcoming the bias-driven distractions that rock your resolve along the way.
- Don’t go it alone – Just as you can’t see your face without the benefit of a mirror, your brain has a difficult time “seeing” its own biases. Having an objective financial planner and independent financial adviser well-versed in behavioural finance, dedicated to serving your highest financial interests, and unafraid to show you what you cannot see for yourself is among your strongest defenses against all of the biases we’ll present throughout the rest of this series.
As you learn and explore, we hope you’ll discover: You may be unable to prevent your behavioural biases from staging attacks on your financial resolve. But, forewarned is forearmed. You stand a much better chance of thwarting them once you know they’re there!