As the UK’s cost of living crisis has continued into 2023, it is becoming harder for many households to manage their finances. Last year, around 8m people were in “financial trouble” or in “financial difficulty”. Fast forward six months, the figure has soared to nearly 11m.
Often, the worst enemy of an investor is him or herself. Biases can lead us to make irrational decisions – not just in our dealings with people, but also with money. Overcoming biases is a crucial part of the process towards becoming a more successful investor.
Below, our Carlisle financial planners identify five common biases that investors can fall prey to. We also include ideas on how to address them continuously, throughout your investor journey. Please contact us for more information or to speak with a financial adviser:
t: 01228 210 137
e: [email protected]
Many people believe that they are better investors than they truly are. We might mistakenly assume that only others make silly mistakes with money. Indeed, the “illusion of knowledge” is a common bias among humans – leading to costly mistakes.
Leonid Rozenblit and Frank Keil, at Yale University, first identified this trait in 2002. For instance, many graduates overestimate their grasp of their university courses once they have left their studies. This tendency to be overconfident can lead investors to ignore key information.
Perhaps an investor ignores an underlying structural problem with an investment fund. Or, they believe they have found an advantage in the stock market which others have missed.
The key to protecting yourself from this bias is to get regular financial feedback (e.g. from an adviser). Whilst this can hurt our egos, it helps to guard against the belief that you are always right. Avoiding “get rich quick” schemes is also a good way to shield against overconfidence.
#2 Confirmation bias
Most humans like to only hear the information which confirms what they already believed beforehand. This is partly why “echo chambers” exist on social media.
The algorithms powering the platforms know that keeping users happy (e.g. by only showing content which reflects their own opinions) will help to keep them on the platform – allowing them to show them more adverts and make more money from advertisers.
Investors can also fall prey to this bias. Maybe they hold onto a stock or fund which is underperforming due to a preconceived notion of its superiority. Financial data which contracts this is ignored, resulting in a weak investment “thesis”.
The best way to address this is to regularly examine your beliefs and test them. Could you be wrong? Seek out contrary opinions and evaluate them. Use multiple sources of information and grow your financial knowledge and literacy.
#3 Herd mentality
Humans are social animals. If we see people around us behaving in a certain way (e.g. buying the latest “hot stock”), then we want to follow them. We have a fear of missing out (FOMO) and do not want to be the only one left behind who missed out.
The problem is, large groups of people can be wrong. Just look at the dot com bubble in the late 1990s. Investors widely over-valued U.S.-based technology stocks and invested lots of capital into them. When the valuations became unsustainable, many of these stocks crashed – leaving lots of people out of pocket. More recently, herd mentality could also be seen at play during the pandemic when investors flocked towards investing in Cryptocurrency.
To guard against herd mentality, work with a financial adviser to agree on a long-term investment strategy to which you remain committed – regardless of whether the market is rising or falling in the short term. Avoid making decisions under pressure (e.g. due to FOMO) and do not be afraid to ask questions about the prevailing narrative.
#4 Loss aversion
Another common human trait is the tendency to feel losses more acutely than gains. When a stock we own rises in price, for instance, the joy this creates tends to outweigh the depression and frustration we might feel if it falls later.
Loss aversion can lead investors to sell certain holdings too early. Perhaps a certain fund underperforms and the investor pulls their money out to avoid further losses. Afterwards, the fund climbs back up again – maybe surpassing its previous value.
To minimise this scenario, investors need a long-term strategy which focuses on gradual, overall growth rather than short-term market “wins”. The more you lean towards a “trading style” of investing, the more vulnerable investors tend to be to this bias.
#5 Gambler’s fallacy
If you hark back to your days of GCSE maths, you may remember learning about probabilities. Suppose you toss a coin and get five heads in a row. Following so many heads, this does not make it more likely that your next toss will be tails. However, many people tend to assume this.
The same confusion around probabilities happens with gamblers. If someone gets a string of “wins” on the roulette table, they might mistakenly assume that they are ‘on a roll’ and that their next throw will also be successful. Similarly, gamblers’ fallacy can lead people to continue betting after a string of losses in the hopes they will win eventually. Investors can also be vulnerable to this gambler’s fallacy.
Maybe they think that their next investment “must” be a winner, because they recently suffered a series of bad luck. Karma must surely be kind to them now! Yet, all too often, this fails to materialise. Protect yourself by treating each investment event as its own entity – not a continuation of any previous investment decisions.
If you would like to discuss your financial plan and retirement strategy, then we would love to hear from you. Get in touch with your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.
Reach us via:
t: 01228 210 137
e: [email protected]
This content is for information purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.