Chances are you think you make rational decisions – about investments and about life. But science has shown that this is not the case.
Accepting that you are not a rational investor is one of the first steps to achieving investment success.
B is for bias
Broadly speaking, there are two types of bias.
- Cognitive biases happen because your brain isn’t firing on all cylinders, so they’re fairly easy to remedy.
- Emotional biases stem from your impulses, feelings and intuitions and are much harder to counteract.
Are you cognitively biased?
Harvard students were asked “A bat and ball together cost $1.10. The bat costs one dollar more than the ball. How much does the ball cost?”
If you said 10 cents you’d be wrong. If the ball costs 10 cents and the bat costs $1.00 more, the bat costs $1.10, so together they’d be $1.20. The right answer is the ball costs 5 cents (and the bat costs $1.05).
Don’t feel bad if you got it wrong: more than 50% of the Harvard students did too. No matter how many times you hear it, you’ll still want the answer to be 10 cents. It just feels right. And when it comes to investing what feels right is often given more weight than what is right.
Matters of the heart
While cognitive biases can be very problematic, they do have an antidote: hard facts such as those contained in annual reports and fund fact sheets. The same, sadly, cannot be said for emotional biases:
- Recency bias is the tendency (inherent in all of us) to believe that something’s more likely to occur just because it’s happened recently. The opposite is also true: if it’s been a long time since something last took place, we forget that it’s even a possibility. A gambler might feel like they’re on a winning streak on the roulette table. But every time they spin the wheel there’s an equal chance of the ball landing on red or black.
- Loss aversion explains why many people are more put off the prospect of losing money than they are attracted to the possibility of earning a windfall. It’s the reason why burning R20k on the stock market can cause you distress for days, but the emotional high of gaining the same amount wears off within hours. Loss aversion also helps explain why so many investors sell shares when market prices are falling. Generally speaking, this is a terrible move as it locks in your losses for good.
- Familiarity bias is why, when faced with a choice – of hedge funds or pizza toppings – most of us stick with what we know. In some aspects of your life this is fine. There’s nothing wrong with always ordering a Hawaiian pizza (on second thoughts, we take that back). But being afraid to try new things is a big no-no in investing. You simply cannot afford to have an undiversified portfolio.
The solution is simple
Emotional and cognitive biases are totally normal. Even financial advisers have them! But we also have the training, knowledge and tools to mitigate them.
The best way of counteracting your biases is to engage the services of an expert financial planner. Once you’ve established a good relationship, all that remains is to take the advice on board and stick to your long-term plan.
It’s also important to focus on things you can control and not fret too much about things you can’t. An example of this is taking advantage of debit orders to make monthly contributions to your retirement investments. In the world of investing, slow and steady always wins the race.
Is something bothering you about your investment plan? Please drop us a line – our door is always open.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.