Investing can be rewarding. It can also be a complex and emotional journey for many investors. Behavioural and emotional biases can often impact investment decisions, potentially leading to poor financial outcomes.
Typically, professional investors are aware of these biases. They have checks and balances in place to try and mitigate their effects. However, retail investors are more likely to allow these biases to influence their actions. This is why the role of a financial adviser is crucial in helping their clients ignore these biases and make informed, rational investment decisions.
Understanding the biases
There are three common human biases that often occur when investing. These may have helped with the evolution of our species, but can be unhelpful on a long-term investment journey:
- Loss aversion: This bias refers to investors favouring the avoidance of losses over acquiring equivalent gains. Studies have shown that the emotional impact of financial losses is more severe than the joy experienced with gains. This bias can lead to irrational decision making. Investors may sell investments during market downturns to avoid further losses, even if it means missing potential future gains.
- Anchoring: Investors often anchor to a specific reference point or to the latest available information. This could be the most recent value of their investment. Any loss relative to this reference point can be perceived negatively, even if the overall investment journey has been a positive one. This can result in an overreaction to short-term market fluctuations.
- Herd behaviour: The prevailing market environment can influence the risk appetite of investors. During rising markets, positive media reports can lead to risk-seeking behaviour, while falling markets can trigger risk aversion. This herd behaviour can cause investors to chase returns in a rising market and sell when values fall. The result often leads to regret when markets recover.
