Even the savviest of us make mistakes with investing – trading too often, refusing to sell losing stocks or chasing past performance. These errors, and many more, are common among investors.
But psychologists and behavioural experts say many of them are deeply rooted in human nature, making them extremely difficult to avoid. I was recently on a webinar with some of the best minds in the business and thought I’d share some of what I learned.
Here we look at the human weaknesses that are damaging your wealth – and how to beat them.
1. The bargain hunter
Everyone loves a bargain, but the impulse can hurt investors. People use a mental process called “anchoring” to determine whether an offer is good value. If you are offered something at a cost of €10, that becomes your measuring stick for all other offers, often without investigating whether €10 was actually a good price.
This means that when the same item is offered for €7 it appears to be good value. Sales people often exploit this fact to make people think they are getting a bargain, said Dimitrios Tsivrikos, a consumer and business psychologist at University College London.
“This is the biggest investment failure people make: they make an investment decision simply because they think they are getting it for a lower price,” he said.
2. The negative nelly
People tend to focus on losses rather than gains.
When presented with an equal opportunity for loss and for gain, an individual will disproportionately focus on the loss, meaning they can miss out on the investment opportunity. Mr Tsivrikos gave the example of someone looking to buy a house for €1m. The buyer is then told that if the market falls they could lose €50,000 in the next two years, but if it rises they could gain €50,000.
In this scenario “we are a lot more alerted by the loss than by the gain, even if it is equivalent”, he said.
3. The loss denier
The same mental focus on losses can make investors who have made a bad call reluctant to cut their losses and move on. “Investors hang on to losing investments when they should have long been rid of them when the thought of crystallising that loss is too painful,” said Nick Blake of Vanguard, the asset manager.
4. The gambler
One trait is particularly influential in investing: the belief that past events will influence the future. “When you toss a coin three times and get heads, many people believe the fourth time will be a head,” said Mr Tsivrikos.
“Investors who have been quite successful in volatile markets are more keen to make a risky decision as they have had a very positive experience. Because they have been lucky two or three times they become arrogant, which leads to them making poor decisions, as they underestimate the investment risk.”
The reverse is also true: those who have had a bad run of investment returns often lose all their confidence and discount good investments, purely on the basis that their previous choices underperformed.
5. The bubble dweller
People like to be proved right, and so seek out information that supports their theories. This is called “confirmation bias”. An investor will make a decision and then find information that backs it up.
The “echo chamber” has been written about a lot recently, with widespread shock at the results of the EU referendum and the American presidential election being blamed on people inhabiting “bubbles” with others who share the same views.
Anthony Rayner, a fund manager at Miton, the asset management firm, said: “Confirmation bias is becoming increasingly important as technology dominates media and as politics becomes more divisive.”
Social media platforms such as Twitter and Facebook are making it harder to escape this bubble, Mr Rayner argued.
“Much of this content gives the user the illusion of being informed but, partly through the power of confirmation bias, it’s largely false confidence,” he said.
6. The hungry investor
Everyone knows you should not go food shopping when hungry, but Mr Tsivrikos said you should also avoid investing when hungry. “Make financial decisions with a full stomach,” he said.
“When we are hungry we tend to make more rash decisions. Make sure you are not in a rush and are giving yourself plenty of time to make your decision.”
7. The do-nothing investor
Finance companies regularly exploit the inertia of their customers – from banks that give you rock-bottom interest rates on savings to the new company pension schemes that allow you to opt out rather than invite you to opt in. But a hands-off attitude can be damaging to investments.
It means you may fail to sell a stock or fund before its fortunes turn, or that you don’t hunt around for the lowest charges or highest rates because it all seems too much bother.
As Vanguard said: “If an investor is considering making a change to their portfolio, but lacks certainty about the merits of taking action, he or she may decide to choose the most convenient path – wait and see.”
8. The cocky investor
People put much greater weight on their own opinions than on the views of other people. “People can feel more confident about their own judgment – they tend to value themselves more than they value others,” said Mr Tsivrikos.
This overconfidence could lead to trading too much in investment portfolios, believing that you can time the markets, and to chasing past performance, warned Mr Blake.
“Another trait called ‘activity bias’ is part of this, when human beings think that doing something is positive, and so are prompted, for example, to tinker with their investments. But doing something can cause more damage than doing nothing,” he said.
Of course, as mentioned above, inactivity can also be harmful at times. The key is to have a rational process behind your investment decisions and to stick to it.
How can you combat these traits?
Being aware of these behavioural flaws is the first stage to preventing them hurting your finances, said Mr Tsivrikos. He also advised investors to use diverse sources of information and get out of their “echo chambers”.
Investors should discuss ideas with family or friends, and preferably with people who have differing opinions, so that their views can be tested.
Writing down the reasons behind investment decisions will also help you review and analyse your choices – and will give you a record to come back to and learn from should things go wrong.
“Stick to four investment principles: goals, balance, cost and discipline,” Mr Blake said. “Very simply, what they mean is to be very clear on what you are trying to do with investments in the first place.”
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