How psychological biases can affect your investment behaviours

When making financial decisions, people often like to believe they are guided solely by logic, analysis, and the numbers. However, the truth is that our emotions significantly influence how we manage and invest our money.

Emotional biases are deeply embedded in the psychology of investors and can be difficult to overcome. By gaining an understanding of these biases and how they affect your financial decisions, it should hopefully lead you to make more informed and rational choices that align with your long-term goals.

Psychological biases affect everyone, so it’s important to understand how they can influence your financial choices. Here’s a look at some of the most common biases.

1. Loss Aversion

Loss aversion is about how you perceive losses and gains. Research suggests that losses tend to impact you more profoundly than gains. For example, if your investment portfolio decreases by 5%, the emotional impact will likely be stronger than if it increased by the same amount.

This cognitive bias can result in risk aversion, causing investors to shy away from valid opportunities that align with their goals. It can also increase the likelihood of panic-selling during periods of market volatility.

While a cautious strategy may seem safe, it could ultimately hinder long-term wealth creation and affect your plans.

2. Confirmation Bias

Confirmation bias is when you agree with evidence that supports your pre-existing point of view.

Researching your options when making investment decisions is crucial. However, confirmation bias may cause you to overlook new information that contradicts your existing beliefs. With this bias, you might favour data that supports what you already think.

For example, if you believe a particular investment opportunity is right for you, you may seek out information that confirms this view while dismissing crucial details that contradict it. This focus on confirming information can lead to investment decisions that aren’t suitable for your goals or financial situation.

3. Herding bias

Following the herd is a natural human tendency that has kept us safe for generations. Many people feel uncomfortable “striking out alone” because it makes them vulnerable to the unexpected.

However, this herding bias can be detrimental to investors, particularly in the age of mass media. If you use social media platforms like Facebook, you may find yourself inundated with “advice” from so-called “experts” on various topics, including finance. These individuals might urge you to “act now before it’s too late”—for example, selling investments while the stock market is falling to avoid potential future losses. Such posts can attract hundreds of comments from those who support the person’s viewpoint.

By allowing yourself to be influenced by the herd in this situation, you risk making poor investment decisions that could harm your wealth in the long run.

It’s natural to want to follow the recommendations of friends and family. However, when it comes to investing, discussing your personal goals with a professional may be more beneficial. A financial planner can evaluate your unique ambitions, discuss your risk tolerance, and create a tailored investment strategy that aligns with your goals, regardless of what the “herd” suggests.

4. Anchoring Bias

Anchoring bias is best described as the tendency to agree with the first, most memorable piece of information we learn.

Anchoring bias occurs when you place too much weight on a single piece of information, causing your views to be “anchored” in decision-making. As an investor, your anchor might be the first data point you encounter, such as the initial value of a stock. If you cling too tightly to this information, you may undervalue other relevant data.

For instance, you might hold onto an investment because of its purchase price rather than assessing its current or future value. This bias can lead you to overlook new opportunities or fail to make changes because you’re fixated on a specific data point instead of considering the bigger picture.

5. Framing Bias

The way opportunities are presented can significantly affect how you perceive them. For instance, if a friend tells you there’s a 20% chance of losing all your money in an investment, you might feel apprehensive about the potential loss. Conversely, if they say there’s an 80% chance of success, it may sound much more inviting.

Both statements convey the same probabilities, yet they can lead to vastly different decisions.

You may be more inclined to take risks if the information is framed positively, emphasising potential gains.

6. Sample Size Neglect

Researching financial options can be overwhelming, given the vast amount of information available. One shortcut that can lead to bias is basing decisions on a small sample size.

If you inquire about savings accounts and rely solely on advice from family and friends, you might follow their recommendations blindly. What works for them may not suit your needs, and further research could uncover better options for you. Additionally, if you notice that a particular sector has performed well recently and decide to invest more in it, you might miss broader trends by focusing solely on short-term figures, increasing your financial risk.

Sample size neglect can lead to overconfidence based on limited experiences. This leads on to another bias.

7. Overconfidence bias

Another common psychological bias is overconfidence, which can disrupt your investment strategy by creating an illusion of control.

Overconfidence bias occurs when investors overestimate their knowledge and abilities, leading to poor decision-making. There is so much information available online these days and not all of it is accurate. Relying on this information can possibly lead to excessive trading and focusing on a few individual stocks, thereby ignoring fundamental diversification principles.

An Outside Perspective Can Help

In summary, it’s important that investors understand these biases, so that they can take the appropriate steps to minimise their effects and make more rational investment choices. And financial advisers can play a crucial role in helping investors navigate these biases.

By providing regular reviews and guidance, advisers can help you stay focused on your long-term investment objectives, avoiding impulsive decisions driven by short-term market fluctuations. Instead, we can encourage adherence to proven investment strategies supported by research and specialised knowledge.

If you are concerned that bias could be affecting your decisions as an investor, or you simply want to learn more about the benefits of our investment management service, get in touch with us today.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

All information is correct at the time of writing and is subject to change in the future.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

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