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How your psychological biases affect investment behaviour

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Tuesday May 20, 2014 at 10:00am
The credit crunch of 2008 highlighted the unpredictable nature of markets. It is the very unsettling nature of such times that really bring home the importance of a coherent, rational and easily understood investment approach. It is through accepting higher risk that investors find the potential to earn higher rewards over time.

It is not possible for anyone to control how capital markets behave but we each individually control how we personally participate in those markets. A sensible start as an investor is to seek advice on assembling a portfolio that meets your long term goals and aligns with your personal capacity to take on risk. Assembling a portfolio with proper diversification and the right mix of assets, along with staying disciplined are crucial if you hope to have a good investment experience.

This last point about staying disciplined is often easier said than done. There are many well documented psychological biases which adversely affect our decision making and which we are all susceptible to. We are human and so tend to behave irrationally from time to time. Here are some of my favourites; you will probably recognise some of them;

Endowment effect: this is the tendency to consider something more valuable simply because you already own it compared to if you didn’t own it.

False consensus: this is the tendency to think that others are just like us. In investing terms we all have our own capacity for risk and required return.

Information cascades: this is the tendency to ignore our own objective information and instead emulate others. For example, an inexperienced investor may buy shares because everyone else is thus driving up the price. They then sell those shares when the price falls through fear which is reinforced by seemingly everyone else selling at the same time. This is known as herd instinct and largely explains why investors buy equities when prices are high and sell when prices are low. Which of course is the exact opposite of what they intended to do in the first place.

Myopic loss aversion: this is the tendency to focus on avoiding short term losses, even at the expense of long term gains.

The Dunning Kruger Effect: psychologists have tested numerous groups where people unskilled in a particular area will make poor decisions and reach erroneous conclusions. Their lack of skill denies them the insight into recognising their mistakes. This gives them illusory superiority leading them to believe their skills in that area are actually above average when in fact they are incompetent.

The reverse effect can be seen in people with real talent whereby they tend to underestimate just how good they are. They tend to think that other people find those tasks as easy as they do when in reality they are way ahead.

It is useful being aware that we all suffer from psychological biases to varying degrees. When it comes to investing the rule is to stay focused to your investment principles and don’t allow random emotional behaviour distract you from those principles and your long term goals set out in your financial plan.

Andy Parker
Chartered Financial Planner Solihull

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