Four behavioural investing errors and how to avoid them
By ATB Wealth 25 April 2023 3 min read
The concept of behavioural investing was first introduced in the 1970s, and there are now decades of research and data that show how ‘faulty’ human reasoning and emotions can get the better of us when it comes to money. Still, it’s not always obvious to investors when they’re making decisions based on feelings rather than logic. Having a better understanding of yourself and your natural tendencies is a crucial step in order to be a successful investor.
Here are some common behavioural errors to watch out for, and a few tips to help you pause before making decisions that might derail you from your long-term goals.
Many people have a tendency to be overconfident, whether it be in their driving skills or when it comes to investing. An unwarranted faith in one’s ability without considering other factors such as luck, can lead to underestimating risks and overestimating expected returns, which can result in a poorly diversified portfolio with significant downside risk.
Action: Try to be self-aware and recognize that overconfidence can lead to bad investment decisions, such as excessive trading or overconcentration. Monitor your emotions too—chances are good that if you’re really excited, there’s probably a catch somewhere. Even if you feel confident in a decision, seek validation from a financial advisor to confirm your instincts.
2. Avoiding confirmation bias
People tend to seek, favour, and recall information that confirms their existing beliefs. An internet search can provide confirmation of nearly any belief while the flow of information on social media is tailored to one's opinions through the use of algorithms. This reality can foster an increased prevalence of this bias. For instance, there might be a hot new cryptocurrency that promises huge returns. You’ll easily be able to find articles to support getting in on it right away, but make sure you also search for articles that talk about the risks and historical performance of this asset. Conversely, the headlines on market volatility might have you convinced to sell, sell, sell but have you looked at a side-by-side comparison of how patient investors who stayed put during low periods fared against those who tried to time the market?
Action: Actively seeking out opposing views can help mitigate the potential for inaccurate conclusions being drawn and can help provide a more holistic assessment of an investment's return and risk prospects.
3. Loss aversion
Nobel Prize-winning research has demonstrated that people are generally 2.5 times more upset over a loss than they are happy about a similar-sized gain. This phenomenon can lead to investors prioritizing avoiding losses rather than achieving gains, which may result in an overly conservative portfolio that does not have the necessary return potential to achieve their goals. Playing it safe is actually one of the riskiest moves you can make.
This natural tendency can also lead to continuing to hold investments in a loss position longer than justified in the hopes that they’ll break even. Conversely, investments in a gain position may be sold earlier than justified out of fear that gains may be lost. The result may be a riskier portfolio when compared to the investor’s risk and return objectives.
Action: This bias can be mitigated by building a diversified portfolio that is aligned with your investment objectives and through a disciplined approach of routinely rebalancing the portfolio back to the target asset mix. Your financial advisor can be a trusted partner to help with this in addition to providing a more objective perspective on what the future probabilities of gains and losses may be.
4. Availability bias
People tend to use their own experiences to formulate their expectations of the future. We estimate the likelihood of particular outcomes or the importance of various occurrences based on how easily information is recalled. An over-reliance on our own relatively narrow range of personal experiences or over-emphasizing recently acquired information can lead to poor decisions.
The availability bias can also lead to poor investment decisions based on an over-reliance on recent events, news coverage and one’s familiarity rather than considering a wide range of factors and perspectives to determine if a decision makes sense for one’s objectives and risk-return profile.
As an example, based on their past experiences, investors that witnessed dramatically different market cycles in their youth generally continued to maintain differing opinions of stocks as a means of building wealth later in their lives.
Action: Inform yourself and broaden your view by reading a wide range of reputable resources, from newspapers to books by investing gurus to financial blogs and articles (like this one!). Use other investors as a soundboard and ask them about their experiences. And finally, talk to experts, like your financial advisor. They can provide a well-informed and balanced perspective to keep you grounded and help you stay on track.
ATB Wealth® (a registered trade name) consists of a range of financial services provided by ATB Financial and certain of its subsidiaries. ATB Investment Management Inc., and ATB Securities Inc. are individually licensed users of ATB Wealth. ATB Securities Inc. is a member of the Canadian Investor Protection Fund and the Canadian Investment Regulatory Organization.
The information contained herein has been compiled or arrived at from sources believed to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy or completeness, and ATB Wealth (this includes all the above legal entities) does not accept any liability or responsibility whatsoever for any loss arising from any use of this document or its contents. This information is subject to change and ATB Wealth does not undertake to provide updated information should a change occur. This document may not be reproduced in whole or in part, or referred to in any manner whatsoever, nor may the information, opinions and conclusions contained in it be referred to without the prior consent of the appropriate legal entity using ATB Wealth. This document is being provided for information purposes only and is not intended to replace or serve as a substitute for professional advice, nor as an offer to sell or a solicitation of an offer to buy any investment. Professional legal and tax advice should always be obtained when dealing with legal and taxation issues as each individual’s situation is different.