If you have a financial portfolio, presumably your investments were chosen with one fairly fundamental principle in mind: to make money. So far so good. Perhaps it’s your intention to proactively manage this process, watching the markets, buying and selling “at the right time” and adjusting your portfolio to capture any potential gains. Perhaps you’re even planning on taking some professional advice.
Making intelligent, evidence backed financial decisions
Whatever your plan, we wouldn’t mind betting that your intention is to make sensible and informed decisions based on evidence and advice. We’re even more certain that it is not your intention to make flippant decisions based on gut instinct, knee jerk reactions, greed and fear, or based on what the guys at the club are all doing. Whatever your intentions are, unless you have a very firm (and independent) hand on the tiller of your investments, then there is a significant chance that you are actually making many of your financial decisions based on emotion, or more specifically, based on a series of unconscious biases. That could be costing you dear.
Like it or not, unconscious shortcuts play a powerful and significant role in your financial decision making, and often to your investment portfolio’s detriment.
The role of unconscious bias
Back in August 2017, we posted about behavioural biases in investing which is hugely under estimated when it comes to investments. We take a look at how unconscious bias may be influencing your decisions and undermining your portfolio. Since the mid-1990s, the evidence and research into the role of emotion and bias in decision making has been building.
You may well have come across the term unconscious bias when at work: the notion that someone favours one job applicant over another because they come recommended by someone well respected or are just wearing your old school tie. The possibility that a suitable applicant doesn’t even get an interview because their name is somehow associated with something you don’t like or respect. In fact, tackling the discriminatory effects of unconscious bias in the workplace is a boom business.
We all operate by way of unconscious bias
Unconscious bias isn’t just an issue at work. Unconscious bias is an essential and inevitable part of our mental thought processes and decision making. Every moment of every day we’re faced with decisions. What socks do I wear? Is it safe to cross the road? Shall I choose X or Y? Do I sell now, or tomorrow? If we had to analyse every aspect of every decision, we wouldn’t get far. In fact, we’d probably still be sitting on the bed thinking “pink socks or black?”. So to help make decision making easier, we have multiple mental short cuts.
We base decisions on past experience, on patterns and on perceptions for example “I will invest in that particular scheme because my colleague successfully did so.” It’s subtle, but this sort of bias does influence us. That means, like it or not, these unconscious shortcuts play a powerful and significant role in your financial decision making, and often to your investment portfolio’s detriment.
Here are some of the ways your emotions may be eating their way into your finances.
- Confirmation bias. Once we decide on something, we unconsciously seek out information which supports that view – often disregarding important counter evidence and giving too much weight to the evidence that is supportive of our opinion.
- Anchoring bias. We have a tendency to reference our decisions to a certain anchor. We bought shares for £9, therefore it would be wrong to sell for £7 but good to sell for £11. That takes no account of the bigger picture and prevailing market conditions.
- Familiarity bias. This creates a tendency to prefer things that are familiar to us – whether that’s the investments you inherited from your father or a UK based (rather than unfamiliar foreign), investment. Again, this takes no account of the overall merit of the investment.
- The herd mentality. Advertising agencies make millions from the human instinct to go with the flow and follow the pack. Indeed, there is evidence that shows, despite the fact that we all know you should buy low and sell high, the opposite repeatedly happens when investors see others panic selling (or buying).
- Loss aversion. We inherently prefer to avoid loss, rather than to make a gain. Even if the risk of loss is very low and the chance of gain is very high. This can make us very susceptible to how things are packaged and described.
- Patterns. We are hard wired to recognise patterns to help us make decisions and or we tend to make decisions based on the evidence of recent events. The fact a particular investment has made a loss for the last 3 years, can lead investors to sell, even though a proper market analysis shows that there was no reason for it continue to do so.
- Fear and greed. Two of the most compelling emotions are also an inherent part of investing and at the heart of many of the above biases. Fear of loss, fear someone else has made better decisions than you, a (perfectly acceptable) desire to make greater gains – these are instincts that are hard to resist.
You may think you’re objective in assessing your own ability but you’re not. There is a huge human tendency to overestimate our own ability as well as a tendency to have a blind spot about our own failings. The most well-known example of this was research conducted in the 1980s which found that 93% of American drivers rated themselves as better than average!
There is a huge human tendency to overestimate our own ability as well as a tendency to have a blind spot about our own failings.
The financial impact
The role of unconscious bias is varied and complex. The impact is undeniable. In a survey (Dalbar Quantitative Analysis of Investment Behaviour, 2009), the performance of the US market overall was compared to the performance of the average investor over a 20 year period. The results? The market delivered a return of 5.3% after inflation (on average per year) while the average investor managed to lose 1% a year after inflation!
Similarly, evidence from the US shows that over the last couple of decades, the greatest investments have been made when the markets are showing very positive returns and the most sales happen at times of bust. So much for buy low, sell high. Why? Because despite all our beliefs in our personal immunity from unconscious bias and in our own ability, we are in fact unable to resist the powerful pull of our own gut instincts.