The human brain uses shortcuts and patterns to process information and make decisions quickly. This can be effective when learning a new language, picking up a new skill or making dinner plans. But it can lead to behavioural biases that can cause us to think and act in curious ways. Particularly when it comes to investing.
1 Source: Morningstar report: Who’s Influenced by behavioural biases? Everyone.
This article explores five common investor biases and how they can influence investment decisions.
How investor psychology can impact investment decisions
Biases can shape many of the investment decisions an investor makes. If left unchecked, these biases lead to deviations from plans - particularly when markets are moving dramatically.
An investor’s thoughts during Feb-June 2020 market swings
2 Source: Nasdaq, S&P 500 prices as of daily close February-July 2020.
Research shows that most people exhibit some bias in their investment decisions. Knowing about these biases and understanding their influence on investor behaviour is key towards curbing their impact on your portfolio.
We can explore these five common biases3 and how they affect investors.
Fixating on a specific reference point, like the price paid for an investment or market index level, and basing decisions around that one number.
Can cause investors to overvalue, or undervalue, asset prices or market performance based on an arbitrary number drawn from past experience.
Tip: Follow a disciplined investment process no matter where markets are headed.
Feeling losses much more intensely than feeling the reward from an equivalent gain.
By prioritizing the avoidance of short-term losses over long-term gains, investors may put the success of their long-term goals in jeopardy.
Tip: Stay focused on long-term financial goals.
Placing too much emphasis on experiences that are freshest in one’s memory — even if they’re not the most relevant or reliable.
Believing that short-term trends will continue into the future may lead investors to ignore new information and be slow to react to changes in investment markets.
Tip: Avoid common investor mistakes by tuning out short-term market noise and focusing on the bigger, long-term picture.
Preferring to invest in what is familiar. – especially from domestic markets. For instance, the average Canadian has 92% of their wealth in Canada.4
Leads to concentrated portfolios that hold only the most familiar investments – especially from domestic markets.This can increase portfolio risk and lead to a bumpier investment experience.
Tip: Invest globally to increase diversification and reduce risk.
Seeking, or accepting, only information that supports what one already believes.
By ignoring information that doesn’t support one’s decisions, an investor can form unrealistic expectations that can lead to portfolio concentration and increased risk.
Tip: Ask big picture questions and develop a more holistic view.
3 Source: The Evolving Role of Behavioral Finance in 2020.
4 Source: Investor Economics: Household Balance Sheet Report- Canada, 2021.
Staying disciplined and focused on the key principles to successful investing can help you reach your financial goals.