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Are your biases hindering your investment performance?

We look at the most common behavioural biases, how they can impact your investment performance, and what you can do to overcome them.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Matt Britzman
Equity Analyst

Published on 18 May 2022

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

How well do you really know yourself? That’s a tricky question to answer, and it might not be one you’d immediately think has any bearing on your investment performance – but it does.

We all have tendencies and biases that creep into our everyday lives, these apply to the investment decisions we make too. Understanding some of your behavioural biases can help you make better investment decisions and keep you from falling into some basic behavioural finance traps.

This article isn't personal advice. If you're not sure whether an investment is right for you, seek advice.

We can’t all be above average

Overconfidence in one’s investing ability is extremely common. It’s a behaviour that applies to all investors. It’s an easy trap to fall into – you don’t need to think you’re Warren Buffett for it to cloud your judgement.

Ask yourself, are you better or worse than the average investor? Most of us would probably say we’re either around average or above. Now of course, it’s statistically impossible for everyone to be above average.

Confidence in most walks of life is a good thing. But when investing, it tends to hinder good risk management. Risk management when building a portfolio helps insulate you from some of the worst outcomes possible. Yet it’s an easy concept to overlook if you have too much faith in your own investing skills.

Has your confidence led you to overinvest in a certain investment? Are you overtrading because you think you know which way the market’s going to move?

There are several ways this bias can hinder performance. One way to make sure you’re not falling into an overconfidence trap is to think about what could happen if you’re wrong. Because yes, even the best investors in the world get things wrong.

That’s where having a diversified portfolio can help. Whether it’s different types of companies, a range of investments – like shares, bonds, funds and property – different parts of the world, or investment styles, there are lots of ways to diversify.

The result is a portfolio that can weather any external storms over the long term, and offer shelter if your analysis on any single investment wasn’t quite on point.

The only investors that don’t need to diversify are those that are right 100% of the time

SIR JOHN TEMPLETON

Diversification – it takes more than a handful of stocks

Losses hurt

Nobel prize winning economist Daniel Kahneman ran a simple experiment with his students. He told them he’d flip a coin, if it landed on tails, they lose $10. He posed the question – how much would they need to win to make the coin flip worth it? The typical answer was more than $20.

A relatively simple thought experiment you can run through yourself, but the takeaway is that losses often carry more emotional value than an equivalent gain. This is loss aversion.

There are a few examples of how this can impact your investment performance.

The first is when an investment starts to lose value because something’s fundamentally changed. The logical, emotionless, investor will re-evaluate the investment. If the fundamentals are still sound and the investment case holds true, then riding the down – or even adding to the position – might be the best course of action.

An investor with a bias to avoid losses might sell out to try and protect against any further drop, missing out on any recovery and further gains to come.

We can see this by looking at previous market downturns and the recoveries that followed.

UK stock market performance following drops

Past performance isn’t a guide to future returns. Source: Thomson Reuters Eikon, 19/07/2021. Where no figures are shown, data is unavailable.

On the flip side, if the investment case has fundamentally changed, then selling, even at a loss, could be the best decision. But for some, there’s a misguided thought that a loss is only real once the investment’s been sold. That fear of a loss, even when there might be better opportunities elsewhere, can result in holding onto a loss for longer than you should.

If you’re looking at individual companies, changing external environments, new management and strategies, or changes to guidance on sales and profit can all be reasons to reassess the business.

Valuation metrics can also help prompt a fresh look and there are several ways to approach this. But if markets are willing to pay more or less for a business’ earnings or sales now, compared to when you bought it, it’s worth doing some digging into why.

Ultimately, be critical of your investments, whether they’ve gone up or down.

Other perspectives can help

The following thought experiment helps convey another common behavioural tendency, confirmation bias.

If a card has a vowel on one side, then it must have an even number of the other side:

A,Q,4,7

Which two cards would you turn over to test the rule?

Most people choose A and 4, because turning these over can confirm the rule. But does that show the rule applies to all cards? No.

A better approach would be to actively look for something that disproves the theory. Flipping 7 could immediately disprove the rule which would be a more useful tactic.

Like this example, most investors look for evidence that confirms their existing beliefs and analysis. If you like a company, do you actively search for analysis that holds the opposite view?

The most comprehensive approach involves looking at a range of opinions. If you still believe in your analysis afterward, you’ve got more reason to act with conviction.

Changing how you think

The first step in trying to avoid bias impacting your investment decisions is to accept that it exists. Once you’re past that step, you can start to look at how to avoid it.

Stock market highs and lows are part and parcel of investing. Its unpredictable nature can be an emotional rollercoaster at times. That’s why understanding both how to invest, and why human psychology plays a key role, is an essential part of becoming a successful investor.

Our team of experts can help with the analysis on a number of shares, sectors and funds to help form part of your wider research.

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