Acting under duress is not ideal at the best of times but under severe pressure the regular psychological effects that impact our behaviour are even more damaging. These emotional distortions affect many aspects of our lives, including how we treat our investments.
Herd behaviour may seem like an obvious example, but it is not unusual to follow the herd; we find safety in numbers. Yet the crowd is not always right, nor wise, so blindly copying the actions of the many can lead us into financial trouble. When all around are selling during a market rout or when money flows into a ‘hot’ fund run by a renowned fund manager, investors must be brave to take what appears to be a contrarian stance.
Loss aversion is related to Daniel Kahneman and Amos Tversky's (1979) Prospect Theory and their famous assertion that “losses loom larger than gains”. In fact, the pain of loss is believed to be about twice as strong as the pleasure people feel from a gain. So it’s not surprising that when markets are tumbling we react so strongly to try and curb potential losses.
Often viewed as one of the most pernicious of human biases, overconfidence leads investors to think they know more than they do – and to act accordingly. One of its effects is for individuals to trade more often than they should (a costly pursuit), or believe they have the skills to read or time the market, and try and eke out gains based on their gut. This belief is usually an illusion.
Anchoring causes us to focus on an initial piece of information when making further decisions. Investors may therefore look to the highest value that their portfolio reached at a certain point – for example, if it touched £300,000 in December 2019 and then languished at £270,000 recently, they may feel they have lost £30,000. But this may ignore the fact that five years ago its value may have been £200,000, and markets typically rise over the long term despite corrections in between.
For example, if we take a look at the FTSE 100 performance chart below, while recent falls may be troubling, over the long term the trend is confidently up.
Source: London Stock Exchange, 2/4/2020
When making a decision we are often persuaded by information which is readily available. If it’s in the news or we can recall it easily we deem it to be important. The implications for investing during market disruption can be profound: if all of the data and daily bulletins are negative, we may act without questioning or without assessing whether the actual fundamentals are sound.
It is common during times of market shocks for active fund managers to state their case loudly – it is relatively easy to identify sectors (for example, travel, retail) that may lag in the short term. But our research into fund data from Morningstar shows that on average active funds don’t outperform passive funds in a downturn*. And finding them is very difficult.
Taking stock of these biases
Being aware of these biases doesn’t prevent them from taking hold or causing us internal conflict during troubling times. But their effects may be mitigated with a little insight into how they assail our emotions and derail our reasoning.
A way to overcome any biases is to look at information objectively – and to try and assess the difference to our wealth that taking an action, or not acting at all, will make.
We may also reduce the impact of our cognitive and emotional shortcomings by choosing a company to diminish their grip on our senses. At Netwealth, our investment professionals have a wealth of experience in handling the biases that individual investors typically face, and we take a robust approach towards managing uncertainty whenever it occurs.
Please remember that when investing your capital is at risk.
* Source: Morningstar/Netwealth data. To end December 2017.