With the volatility in the markets this quarter it is a good time to discuss a few aspects of behavioral finance. Behavioral finance is a field of study that combines psychology and economics. It discusses that as human beings, investors are not always rational or logical. People are subject to personal beliefs and/or biases that may lead to irrational and emotional decisions. These beliefs and emotional reactions can have a significant impact on your investments and the ability to meet your financial goals, as they sometimes drive decision-making. Acknowledging and understanding these biases and taking steps to avoid them are the best way to make sure you make appropriate, rational investment decisions.
The following are a few of the common biases that cause investors to make illogical investment decisions.
1. Confirmation Bias
Confirmation bias is the tendency to seek out information that supports our pre-existing ideas. When picking investments, we often look for information on products or companies that we want to hear and would justify our decisions to select them. This can be dangerous and costly.
How to Avoid this Bias: Take the time to consider all of the information available to you before making a decision – do not act hastily. Ask your advisor to help you gather data to make educated investing decisions.
Anchoring occurs when investors fixate on past prices and information. It is easy to get “anchored” to the price of a stock, the level of the market, or past performance - focusing on what we think we should get rather than what we can reasonably achieve moving forward. This can cause investors to reject rational investment decisions and subsequently lead them to hold onto losing investments or purchasing investments which are now overvalued.
How to Avoid this Bias: Thinking critically is your best defense against anchoring. Your advisor can help you with this by allowing him/her to play the role of devil’s advocate; listen to different perspectives and let yourself see the information you may be missing. This can include analyzing the rational of current prices compared to rational prices and market conditions moving forward. Successful investors base their decisions on many relevant factors, not just one piece of data. Usually, a high-level macro view is more predictable then having a micro economic view.
3. Mental Accounting
Mental Accounting is the term used to explain our tendency to assign different buckets of money to different functions. We tend to allocate our assets in sometimes detrimental and irrational ways. For example, we may consider our tax return “bonus money”, and therefore spend it more frivolously, when it could have been applied to debt or deposited into retirement savings or tax-free savings account (TFSA). This type of thinking can hold you back in reaching your financial goals.
How to Avoid this Bias: Money is money, and should be treated as such no matter the source. Ask your advisor for help organizing your financial priorities and treat all money as earned income.
Being overconfident sometimes makes you think you know more than you really do in a certain situation. This is not to downplay your knowledge, it simply happens occasionally. Sometimes all it takes is one big win, and we become irrational with our investment decisions. You may begin to trade more rapidly, which is rarely worth the costs, or start under diversifying in hopes of hitting it big again. It is also natural to remember the big wins and not want to think about the losses, thus remaining overconfident. Currently, this can especially be relevant to the cannabis sector.
How to Avoid this Bias: Recognize that there is a point where you can be too involved with the details of your investments and it can result in taking on more risk than you require. This can result in significant downside losses. In my experience in public accounting, many DIY investors have this bias, although when I have done their tax returns at year-end, the results are too often different than what they expected on an overall basis. Be sure that the decisions you are making are driven by reason, not emotion.
5. Loss Aversion
On the opposite end of being overconfident, is suffering from loss aversion. Loss aversion is when we focus so heavily on not losing money, we neglect the fact that we could be making money. This type of thinking can cause us to have unbalanced portfolios, keep us from unloading unprofitable investments, and hold us back from realizing our financial potential.
How to Avoid this Bias: Feeling the pain of loss is a completely human experience and it is only natural that we want to avoid it at all costs. Every decision should be made as of the point in time, using all available information as of today. Focusing on past performance can hinder future results. Try formulating a plan with your advisor on what you will do if your investment loses. That way you have a rational plan in place that will keep you from making emotional investment decisions that could hurt your portfolio further.
The Bottom Line
We all possess a unique combination of rational and irrational traits when it comes to investing – this is natural human behaviour. The good news is, being self-aware and educating yourself can help you overcome any hurdles you may face. The first step is talking to a financial advisor. An advisor can help you moderate and adapt to your biases, keeping you on track to meet your financial goals.
Andrew Brydon, CPA, CA