6 Behavioural Biases Affecting Your Portfolio and How to Minimise Them
Traditional economics and financial theory rests on the assumption that people act rationally – considering all available information leading them to optimal outcomes and supporting the efficiency of the markets. The reality is that investors are marred by behavioural biases which can negatively affect their financial decision-making and in turn, their portfolio returns. The good news is you don’t have to be your own worst enemy – you may be able to improve your investing acumen by recognizing these biases and employing strategies that can minimise them.
Conservatism Bias
This happens when people maintain their prior views by inadequately incorporating new, conflicting information to their forecasts. This behaviour relates to an underlying difficulty in processing new information. Some investors may be slow to update information or prefer to maintain a prior belief rather than deal with the mental stress of updating beliefs given complex data.
One of the best ways to counter this bias is to seek professional guidance from a certified Financial Advisor or Investment Representative if you find certain new information is difficult to interpret or understand. They can explain its implications on your portfolio.
Loss-Aversion Bias
This is the tendency to prefer avoiding losses to achieving gains. Indeed, for most investors the pain of losing is psychologically twice as powerful as the pleasure of gaining. Loss aversion leads to holding onto losers in your portfolio to avoid recognizing losses and selling winners to lock in profits.
To mitigate this bias, avoid getting too emotionally involved in your investments. There are risks involved in investing and many of these risks are beyond your control. A prudent investor accepts that they can’t be right all the time. Sometimes, it is better to book a loss – use it as an opportunity to practise stoic acceptance, and move on to alternative investment options.
Illusion of Control Bias
People tend to believe that they can control or influence outcomes when in most cases they cannot. Some can infer causal connections where none exist – a classic example is people preferring to choose their own lottery numbers over random numbers selected for them.
The truth is even the largest investment firms have little control over the outcomes of the investments they make. Companies are subject to macroeconomic and industry forces that are mostly out of their control. To overcome this bias, always keep in mind that investing is a probabilistic activity and avoid investing more money in a single venture than you are willing to lose.
Confirmation Bias
This refers to the tendency to look for and zone in on what confirms prior beliefs and to ignore or undervalue whatever contradicts them. Confirmation bias reflects a predisposition to justify to ourselves and believe what we want to believe.
This bias can be minimised by actively seeking out information that challenges your existing beliefs, that way you can corroborate your decisions with additional sources of information for a more holistic perspective. An example is reading different research reports from multiple sources.
Availability Bias
This is an information-processing bias in which people estimate the probability of an outcome or the importance of a phenomenon based on how easily information is recalled. As a result of this bias, people may limit their investment opportunity set - sticking only with investments familiar to them, choose an investment based on the “hype” or amount of news coverage, and fail to diversify.
To overcome this bias, investors should develop a clear and appropriate investment policy for themselves, carefully research and analyse investment decisions before making them, and focus on long-term historical data.
Endowment Bias
This is a bias in which people value an asset more when they own it than when they don’t. Effectively, ownership “endows” the asset with added value. This bias can lead to investors failing to sell an asset to replace with a better one or maintaining an inappropriate asset allocation. It typically arises when the asset is inherited. Often in these situations, investors cite feelings of disloyalty associated with the prospect of selling inherited securities and general uncertainty in determining the right choice.
A good way to minimise this bias is by asking yourself, “If an equivalent sum to the value of the investments inherited had been received in cash, how would you invest the cash?”
Ultimately, investors are only human and it’s easy for anyone – including myself – to succumb to these biases. November is Financial Literacy Month in Canada and I hope this article helps improve your understanding of behavioural biases and reduce their effect on your investing habits.
The information contained in this article is not intended and should not be used or construed as an offer to sell, or a solicitation of any offer to buy, securities of any fund or other investment product in any jurisdiction. The information in this article is not intended and should not be construed as investment, tax, legal, financial or other advice. Past performance is not indicative of future performance.
