{"id":674,"date":"2016-09-14T13:04:19","date_gmt":"2016-09-14T20:04:19","guid":{"rendered":"https:\/\/chaltenadvisors.com\/blog\/?p=674"},"modified":"2016-09-14T13:04:19","modified_gmt":"2016-09-14T20:04:19","slug":"4-important-psychological-biases-for-investors-to-understand","status":"publish","type":"post","link":"https:\/\/chaltenadvisors.ca\/blog\/4-important-psychological-biases-for-investors-to-understand\/","title":{"rendered":"4 Important Psychological Biases for Investors to Understand"},"content":{"rendered":"

In our last post<\/a> we highlighted that behaviour<\/em>\u00a0might just be the biggest source of trouble for investors. \u00a0People just aren’t psychologically wired to make investment decisions that are good for them and often do things that are potentially harmful. \u00a0Our brains have evolved to create\u00a0protection mechanisms that in many instances are helpful – just not when it comes to investing! \u00a0The\u00a0subconscious creates short cuts designed to save us time when making decisions and to protect us from pain, both emotional and physical —\u00a0basically these short cuts\u00a0help us perform better in “fight or flight” situations. \u00a0While many of these\u00a0biases and their implications for investors have been documented by the likes of Daniel Kahneman, Amos Tversky and others, we think the following four stand out:<\/p>\n

    \n
  1. Familiarity Bias<\/strong> – we tend to stick with what we know, whether that is products we buy, places we frequent or stocks in which we invest. \u00a0Presumably this heuristic evolved over time to help us make quicker decisions and keep us safe but when it comes to investing it can have the opposite effect. \u00a0For example Canadian investors tend to overweight their portfolios towards Canadian stocks, a common phenomenon globally but Canadians are among the most extreme examples of what’s known as “home bias.” \u00a0 While Canadian investors might feel more comfortable owning the shares of companies they read about in the news most often and that are closely tied to our own economy, from an investment perspective they are taking on unnecessary risk by being overly exposed to specific companies in the oil, mining and financial sectors. \u00a0Canadians would be better off from a risk and reward perspective if they were to diversify more outside of Canada.<\/li>\n
  2. Recency Bias<\/strong> – we tend to remember things better that happened more recently than we do things that occurred further back in time. \u00a0If you look at expert forecasts from Wall Street analysts going back in time, they tend to forecast very high returns just at or following market peaks (like the internet bubble) and low returns following market bottoms (like during the 2008\/2009 financial crisis) —\u00a0clearly not very helpful and if so-called experts fall victim to the same biases, what chance do the rest of us have? \u00a0Markets are volatile and move in cycles —\u00a0anchoring on recent trends or sentiment might lead us to make decisions that result in the opposite of what’s good for us.<\/li>\n
  3. Overconfidence Bias<\/strong> – Daniel Kahneman believes this to be\u00a0the most dangerous of all behavioural biases and the most difficult to overcome. \u00a0Just like driving ability, people tend to believe they have a better than average ability to\u00a0pick outperforming investments or investment managers. \u00a0This bias leads people to ignore overwhelmingly convincing evidence, often at their peril. \u00a0For example, despite the fact that data shows that paying high fees for active investment management leads to lower returns on average and greater uncertainty of outcomes, people continue to try to beat the market or find winning investment managers. \u00a0(Full disclosure, Chalten Fee-Only Advisors espouses an evidence-based low cost, largely passive investment philosophy!).<\/li>\n
  4. Herding<\/strong> – it’s a lot more painful to be wrong on your own than be wrong when everyone’s wrong. \u00a0Surely the herding mentality stems from some innate desire to feel included, to avoid being exposed whether right or wrong. \u00a0The result of herding in the investment world is that once trends develop there tends to be\u00a0a “bandwagon effect” that becomes difficult for many investors to resist. \u00a0“Fear of missing out” or FOMO as it’s popularly acronym-ed\u00a0these days can drive individuals to make irrational investment decisions they might normally avoid if deciding\u00a0independently.<\/li>\n<\/ol>\n

    The net effect of the above is that\u00a0people make investment decisions that are harmful. \u00a0Often the result is that investors buy into euphoric market peaks and sell out at the bottom of market panics. \u00a0It is no surprise that studies\u00a0show that investment returns earned by individual investors are not only lower than market index returns but lower than those of the mutual funds in which they invest —\u00a0\u00a0investors\u00a0just get in and out at the wrong time. \u00a0And if it’s not enough of a struggle\u00a0that we have these psychological biases to battle against, most of the financial media and investment industry use\u00a0communication and advertising practices that are specifically designed to exploit all of our\u00a0psychological pitfalls! \u00a0How can you win? \u00a0To begin with, develop a investment plan that fits in with your overall financial plan. \u00a0Define parameters that address your ability, need and willingness to take\u00a0risk and then use your plan as an anchor (in this case an anchoring bias is OK!) to keep you on track\u00a0and avoid being swayed by both external noise and internal psychological biases.<\/p>\n","protected":false},"excerpt":{"rendered":"

    In our last post we highlighted that behaviour\u00a0might just be the biggest source of trouble for investors. \u00a0People just aren’t psychologically wired to make investment decisions that are good for them and often do things that are potentially harmful. \u00a0Our brains have evolved to create\u00a0protection mechanisms that in many instances are helpful – just not […]<\/a><\/p>\n","protected":false},"author":2,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[16,19,7,14],"tags":[],"class_list":["post-674","post","type-post","status-publish","format-standard","hentry","category-asset-allocation","category-financial-planning","category-graham-bodel-posts","category-investment-industry-issues"],"_links":{"self":[{"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/posts\/674","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/comments?post=674"}],"version-history":[{"count":1,"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/posts\/674\/revisions"}],"predecessor-version":[{"id":675,"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/posts\/674\/revisions\/675"}],"wp:attachment":[{"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/media?parent=674"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/categories?post=674"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/chaltenadvisors.ca\/blog\/wp-json\/wp\/v2\/tags?post=674"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}