Behavioural biases play a significant role in our decision-making as investors.
Whether we realise it at the time or not, these inherent biases can sometimes contribute more to our portfolio returns than the assets or funds we select.
A new briefing note from investment software provider Dynamic Planner has highlighted the value of understanding behavioural biases, along with other factors, to improve investment outcomes massively.
They explain that there is extensive evidence about the impact of behavioural biases on investment decisions. But the factors that influence our susceptibility to these biases are less well covered.
By understanding how personality traits and behavioural biases influence our investment decision making and then taking some steps to counteract them, we can reduce the likelihood of making poor investment decisions.
Five essential traits that define personality were identified.
There's conscientiousness; the extent to which we are dependable, orderly, organised, responsible, practical, thorough or hardworking.
Neuroticism occurs when we're feeling depressed, tense, nervous, angry, unstable, envious, worried or uneasy.
There's extraversion, which drives being sociable, outgoing, energetic, talkative, bold, assertive and adventurous.
Another essential personality trait is the openness to experience, which has the characteristics of being creative, imaginative, intelligent, analytical, reflective, curious and open-minded.
Finally, there's agreeableness, with the characteristics of being courteous, polite, trusting, nice, kind, gentle, pleasant and sympathetic.
The briefing note outlines below how these characteristics fit with the well-known investment behavioural biases along with five ways clients can reduce or avoid them:
Herd mentality (agreeable and/or introvert personality traits) – This relates to investors basing their decisions on the actions of others. Whether spurious (making similar decisions to others) or intentional (deliberately imitating behaviour) herding, both can be detrimental.
Investors can avoid herd mentality by not trying to time the market – this can be typical of investors engaging in herding behaviour. Such investors risk making losses and missing out on the highest periods of growth. It is, therefore, best to stay invested and follow the plan.
Anchoring bias (conscientious, agreeable and/or introvert personality traits) – Investor decisions can be influenced by fixating on a reference point due to uncertainty of assets. They then go onto make comparisons and estimates based on this which is known as anchoring, even though the reference point is arbitrary and irrelevant.
Anchoring can result in the ‘disposition effect’ where subsequent investment decisions can be negatively affected by holding onto losing stocks or funds for too long or selling winning ones too early.
To avoid anchoring bias, investors must be objective, communicate with their financial planner and/or make research-based decisions to be less vulnerable to anchoring.
Another common investment behavioural bias is overconfidence bias (extravert, openness to experience and/or disagreeable personality traits) – Investors who are overconfident and overoptimistic may take greater risks.
Overconfidence can manifest in an overestimation of investment knowledge and result in an underestimated perceived level of risk. It can also be increased by ‘confirmation bias’ - where new information that supports an existing opinion increases confidence.
To avoid overconfidence bias, investors need to consider the consequences of their actions!
Overconfidence can lead to attempting to time the market due to a perceived level of skill and illusion of control. However, when things go wrong this can result in a greater loss.
There's also regret aversion (conscientious and/or emotionally unstable personality traits) – Anticipating regret and envisioning the emotional discomfort of making a poor decision can result in inertia, where investors fail to act or stick with a default option for fear of making an active choice which later turns out to be sub-optimal.
To avoid regret aversion, investors need to have a systematic approach – following a plan with a diversified portfolio focused on long term investment goals will help investors regulate emotions and avoid succumbing to feelings of fear and regret.
Investors sometimes fall victim to recency bias (emotionally unstable and/or closed to experience personality traits) - Investors evaluate the likelihood of future events on recent memories without putting them in the perspective of the longer-term past.
This often relates to information that is easily accessible and available which can lead to poor investment choices.
To avoid recency bias, investors should have a long-term view for long-term investments to avoid short-term thinking which can lead to recency bias.
Louis Williams, Dynamic Planner’s Head of Psychology & Behavioural Insights said: “Behavioural biases can influence risk tolerance levels and impact investment choices. However, if advisers can make investors more aware of the powerful biases that can influence their attitudes and behaviour towards financial risk, they can also help them to manage their investment journey in a much more positive way.”
Helping clients have a better understanding of their own personality and attitude to risk can certainly help, particularly when faced with market uncertainties and volatility.
To discuss this, or for help and advice with your investment planning, contact us.