Are your biases sabotaging your investments?


Jason Prowd  |  21 November 2018  |  8 min read

Key Points
  • Your brain has natural biases that streamline decision-making but can push you towards poor choices.
  • These biases can lead to serious setbacks when it comes to investing.
  • Building a diversified portfolio can help you avoid negative consequences from many types of bias.

Where would humans be without our ability to crunch a ton of information in seconds? Probably still in a cave, hunting for our next meal and watching fire instead of relying on Deliveroo and Netflix.

Impressive as our brains are, they’ve also evolved to be selective and subjective. Biases are hardwired shortcuts that streamline decisions, so we can quickly pick pizza or pho for dinner, and just get on with our lives. But our naturally swift decision-making can be a disaster, especially when it comes to money and investing.

There are hundreds of biases. Let’s unpack a few of the more significant ones that can impact our investing outcomes. 

Confirmation bias–rose-tinted glasses

When we already think something is a good idea, we’re far more likely to notice information that backs us up. So we ignore—or don’t even seek out—things that make a bad outcome likely.

What does this look like in investing terms? You get a tip from a trusted friend. But you know better than to blindly accept it, so next you research, sifting through a heap of data and opinions. With confirmation bias, our attention is drawn to the information that reinforces what we already have in mind. It makes for a very one-sided decision-making process. And with less chance of risks being revealed, you’ll feel completely blindsided if things don’t pan out. Conversely, when your portfolio does well, your brain reacts with dopamine—the feelgood chemical that makes decision-making even more primitive.

You can fight this bias by deliberately searching for conflicting information. When you make your choice, you’ll know that it’s as objective as possible. 

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Loss aversion–once bitten, twice shy  

Research tells us the pain of a loss hits hard, far more than the kick you get from a win. And if you’ve been down on your luck with investing, you’re likely to go to some lengths to avoid losing big again, making you too risk averse to properly evaluate investment options. Deciding not to invest at all and keep your savings in cash is loss aversion taken to an extreme.

Being haunted by losses past can be made even worse when endowment bias comes into play. The loss hurts so much, you keep an asset even longer, hoping it will pay off eventually. This is just one example of this bias: even when it’s a poor competitor for investment dollars compared with others you don’t already own.

Fighting the urge to constantly check on your portfolio is a good way to steer clear of loss aversion, so you won’t be hung up on short-term dips in individual asset values. An even better safeguard is making sure you’ve got a risk-adjusted, diversified portfolio, designed to earn steady returns over time. 

Anchoring bias–the power of suggestion

A not-so-distant cousin of confirmation bias, anchoring happens when the brain is convinced of the ‘right’ number based on suggested options. This effect can really bump up your restaurant bill, for example, if you read from the bottom of the wine list instead of the top. An $80 bottle seems like a steal when you could be spending $250.

It’s easy to see how you can get hooked on the idea of selling – or buying – shares when they reach a certain price. But what matters in any investment is the difference between what an asset is estimated to be worth and what you can trade it at. Just because something has doubled doesn’t make it expensive, and just because something has halved doesn’t make it cheap.

A fixation on chasing returns by timing the market can lead to all sorts of investing problems, including the tax and fee burden of churning through lots of transactions. And that brings us back to the inherent value in a diversified asset portfolio, held for the longer term. 

Others worth a mention

Groupthink–jumping on the bandwagon instead of ignoring the hype and doing your own research and analysis.

Overconfidence bias–placing too much faith in the quality of your information and/or judgement. See also: hindsight bias.

Hindsight bias–classifying past events as predictable when they’re positive, and unpredictable when negative. In practice, this means you take credit for the wins and put losses down to a cruel twist of fate nobody could’ve seen coming. Not the best mindset for learning from mistakes. 

It’s nearly impossible to immunise yourself against biases, and different biases will affect you in different ways. What you can do, though, is reflect on which biases might be your biggest blind spot. We all have them—I have many. There are a few different ways to do this: you could take a quiz that helps you find those blind spots (like this one from Kiplinger), or examine your investing history and see if you can find parallels between your decisions and the market at that time. You can also mitigate bias by building a diversified portfolio or deferring to a professional—all key parts of a sound investing strategy.

So what’s my main takeaway here? Yes, your biases are almost definitely impacting how you invest. But now that you know that, you’re already doing better than most investors. Check yourself, diversify, and ask questions.  

author

Jason Prowd leads Morningstar Next: ready-made investment portfolios.


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