Humans make terrible investors because of behavioural biases that we are often unaware of. We are more irrational than we might think; to the extent that we are predictably irrational.
The ironic part is that we often make bad decisions when we think we are being most logical; the reason for this being that we find patterns where there are none.
It is common for our brains to see patterns, regardless of whether or not they exist. However, our intuition and application of probability in the real world is often very skewed.
Our built-in pattern recognition also makes us susceptible to being struck by panic during Black Swan events, which are unpredictably rare, catastrophic events with severe consequences (e.g. Covid-19).
Let’s be completely honest, none of us saw a global pandemic coming at the start of 2020! Even during the first lockdown in Wuhan, we never imagined how far-reaching the effects of the virus would be.
I still feel like we’re coming to grips with the fact that we spent the best part of 2 years in lockdown.
As one of the most introverted people around (‘INFJ’, if you are wondering) lockdown has had it’s benefits but the uncertainty has been stressful at times; as I’m sure it has been for you.
We want the world to be as predictable as possible, and events that are contrary to this expectation result in uncertainty which is stressful for most people.
We are also emotional and struggle to regulate our emotions when it comes to money, which can cause us to make unusual or strange decisions (see; emotional bias).
These are just two examples of how our emotions influence our behaviour.
Join Our Newsletter!
Get content like this in your inbox every Friday
Investing Is 90% Psychology, 10% Knowledge
You can know everything there is to know about investing, but constantly set fire to your investments if you don’t keep your emotions in check. By contrast, you can know very little but be a phenomenal investor if you keep calm and carry on.
“Investing is not the study of finance. It’s the study of how people behave with money”.
As illustrated by the below chart, investing can be an absolute roller coaster for many:
One of the biggest influences on your returns is the way you behave and respond to behavioural biases. By taking the time to understand the psychology that drives your investing behaviour, you can become a much better investor.
And there are some useful strategies you can learn to overcome your behavioural biases and avoid damaging your investment returns.
This article will also help you learn some surprisingly simple ways to detach your investing behaviour from the emotional bias to improve your emotional investing experience.
Why You Might Make Poor Investment Decisions
According to Daniel Kahneman, author of Thinking Fast and Slow there are two types of thinking.
- Type 1 is fast, intuitive, unconscious thought but also very susceptible to heuristics (mental shortcuts).
- Type 2 is slow and requires conscious effort but is much more resistant to cognitive biases.
Heuristics can help us solve problems and speed up our decision-making process and help us make efficient decisions in everyday life (e.g. the supermarket).
I’m pretty indecisive at the best of times. So, if it wasn’t for these snappy decisions, I’d never actually finish my weekly food shop.
Imagine, if you had to make a detailed analysis of every item you picked up before adding it to your basket! Come to think of it, I’d probably never decide if I wanted to go to Morrisons, Sainsburys, Lidl or Aldi. There is simply too much choice.
The problem is that our investing decisions often unconsciously utilise ‘Type 1’ pathways and the underlying heuristics and behavioural biases might cause you to make poor investing decisions.
This feeling is doubled by negative emotions that stop us from thinking clearly. All of which makes us more dependent on heuristics, which further affects our thinking.
For example, in the event your investments start to lose money, you might think that you will be able to control your emotions and avoid panic selling behaviour.
This can be highly problematic for investors and cause them to abandon their investing strategies.
Risk aversion: We Hate Losing More Than We Like Winning
You only have to look back to the Euro 2020 final of England vs Italy to understand just how much losing hits people emotionally. You don’t have to look far to see pictures of distraught players and fans.
A win is just not on the same spectrum as losing and a loss is felt twice as powerfully as the pleasure of gaining.
It’s the same with our money; we feel the impact of losing money in the stock market more than we enjoy gaining it.
This results in risk aversion which is the reason investors prefer certainty to uncertainty.
This is one of the primary behavioural biases of investors to overcome, as it forms the foundations for much of our negative investing psychology.
The University of Chicago Press framed this well, “someone is said to be risk-averse if they are disinclined to pursue actions that have a non-negligible chance of resulting in a loss or whose benefits are not guaranteed”.
In other words people will avoid investing and save in cash because there is a minimal chance of loss and the probability of a good return is not guaranteed.
Why Do You Fear The Stock Market?
A survey by finder.com found that only 33% of people in the UK own shares and 33% have no plans to invest. This situation is very similar in the US, Yahoo Finance puts it as 42% and Go Banking Rates at 55%.
A high proportion of those surveyed reported that they do not invest in the stock market because they either do not trust it or are afraid to lose money.
As we can see, many people never start investing in the stock market and those that do may be easily scared away from investing by stock market crashes.
This is because we often learn that the stock market is as risky as gambling and that people often lose money in the stock market.
As a result, our investing psychology is anchored and overly influenced by the first bit of information we have heard about the stock market (see, anchoring bias)
If you are a Millenial, like me, you will have grown up through the dot.com crash, graduated around the time of the Great Recession, and are now living through Covid-19. Not exactly the best time to enter either the workplace or investing arenas!
Understandably, you might find it hard to acknowledge that historically the stock market has always trended up, because of your beliefs being anchored in negative news articles about the economy.
Probability: We Are Terrible At Making Accurate Predictions
In any given year, you will see a constant stream of articles predicting a stock market crash. If you type stock market crash 2021 into google, it will return around 38,400,000 results. All of which creates negative behavioural biases.
As such you could be forgiven for thinking that stock market crashes are highly frequent events that you fear.
You might also remember being told that the stock market is a very risky place to put your money because of this.
This is certainly one of the money myths I learned from my Mum growing up. Much to my annoyance she still likes to tell me property is the only safe place to put your money (Ok, Boomer!)
It actually took me a while to override how the stock market was framed for me and become a confident investor.
This is because when you are trying to make a decision, you will frame your decision in a framework of existing memories; which are deemed to be relevant. This is known as the availability heuristic.
These memories are often more readily available given that they are often entangled with our emotions. Which often causes us to judge events as being more common or frequently occurring.
The Non-Flying Dutchman
We all know that person that won’t fly or hates to fly. I used to love the Arsenal player Denis Bergkamp growing up, I even named a pet goldfish after him! Much to my disappointment, he would never be able to play in an internal away game because of his Aviophobia (fear of flying).
Oddly, as far as I’m aware Bergkamp never had a fear of driving.
Rationally speaking, if you have Aviophobia, you should also have a fear of car crashes (Vehophobia, Amaxophobia). After all, your odds of dying in a car crash are 1 in 114, while your odds of dying in a plane crash are 1 in 9,821.
Despite this fact, the fear of car journeys (6% of people), is as common as the fear of flying (up to 6.5% of the population), despite your probability of being involved in a car accident being significantly higher.
It’s the same with investors and stock market crashes. In reality, bear markets have occurred only every 7 years since 1950.
And as a result, investors make poor investment decisions because we are afraid of events that we think are more likely to occur than they are.
Why You Expect To Lose Money In The Stock Market
This can be skewed by both optimism as much as pessimism. It’s probably a hangover from our hunter-gatherer days; the human that got nervous about a rustle in the bushes, survived longer than the one that assumed it was just a gentle breeze.
It’s an emotional bias that often results in the panic selling of investments at the first sign of trouble.
People will often sell in a temporary dip, only for the stock market to trend upwards; they then have to buy back in at a higher price.
Join Our Newsletter!
Get content like this in your inbox every Friday
Similarity Between Events
The similarity between past and current events can also create behavioural biases.
When investors see the signals of a previous stock market crash, such as an ‘all-time high’ they assume that a crash is just beyond the horizon.
I have lost count of the number of times I have seen this cited in a news article as a reason for an imminent market crash. I even convinced myself of it at times and I was frequently wrong!
It doesn’t take much for investors to be spooked and even small triggers of volatility can make many anticipate a correction or bear market.
The following day the market jumped back up, as ‘investors bought in the dip’ despite the fear of Covid resurgence (the reasoning behind the drop) not dissipating to any degree.
Regardless of all the rational explanations behind these peaks and troughs, it’s clear that nobody can predict what the stock market will do next. Your guess is as good as mine, and anyone who pretends otherwise is kidding themselves.
Randomness Of Events
The term “bull market” is most often used to refer to the market conditions where prices are rising or expected to rise. By contrast, a “bear market” is a period of prolonged price decline, following a fall of 20% from a recent high.
Although Bull and Bear markets are naturally unpredictable economic cycles; bear markets are often perceived as more likely to occur.
This is because a behavioural bias stems from the randomness of these two events; we can flip from a bull to bear market at any time.
As bear market crashes don’t have any logical sequence, they’re regarded as representative of randomness and thus more likely to occur.
In fact, the longer the bull market runs over the average (7 years) the higher people assume the probability of a bear market is. If you flipped a coin 9 times and they all landed on heads you might predict that the next coin must land on tails, even though the probability is still 50/50.
The 2009-2020 bull market was the longest ever, but many will have cashed out in 2015 or 2017 due to assigning a much higher probability to a stock market crash (even though it would run for another 3 to 5 years).
#5 Crucial Ways To Become A Better Investor
There are endless reasons why humans make irrational investors, but there are some great ways to overcome your behavioural biases.
- Reduce your risk aversion
- Diversify your portfolio
- Invest long-term to Improve your returns
- Don’t check your portfolio too frequently
- Consider investing in fully managed but passive investment portfolios
#1 Reduce Your Risk Aversion To Investing
Before we go any further please remember that when investing your capital is at risk. The value of your portfolio can go down as well as up and you should seek financial advice if you are unsure about investing.
Harvard Business Review outlines some key ways that business managers can overcome behavioural biases such as risk aversion. I believe these can be applied to investing:
- Make risky decisions in batches: By batching up your investment decisions such as which fund, assets, fund manager, you can, by-pass loss aversion. ikigai’s personalised three step process can relieve much of the investing stress.
- Bring risk out into the open: Invest with a company that is transparent about your potential portfolio returns. By understanding the risk and volatility you prepare yourself with a strategy for when the stock market crashes.
- Make risk less personal: Remove yourself as an obstacle to your investments by automating your investments. People who interfere less with their investments often do better than those that meddle.
#2 Diversify Your Portfolio
Modern Portfolio Theory (MPT); states we should seek efficient diversification by spreading risk across the entire market. As a result, we are exposed to the maximum return whilst minimising the risk.
MPT is an excellent approach for risk-averse investors and how they can construct portfolios to maximize expected returns based on a given level of market risk.
In short, the theory suggests that a broad-based index fund approach is suitable for the majority of investors. One that can help you to sidestep your behavioural biases.
What Is An Index Fund?
An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.
- The S&P 500 tracks the top 500 companies in the US stock market
- The FTSE 100 tracks the top 100 companies in the UK
- EURO STOXX 50 – 50 large blue chip companies in the Eurozone
An investment strategy that simply tracks one or more of these indices is referred to as passive investing.
Don’t worry, you don’t have to do all of this yourself. You can use a single wealth manager, like ikigai, to diversify, rebalance and maintain your portfolio for you.
#3 Invest Long-Term To Improve Your Returns
There is a commonly cited Fidelity study (although it has never been verified) that learned that those with the best returns were “either dead or inactive.” Although it might have never taken place, the theme still runs true.
This is because, rather than trying to beat or actively attempting to avoid loss, it can be more optimal to be a passive investor in an index fund.
Although the stock market has been extremely volatile, over time it has grown at an average annual rate of 10 to 11% since 1926.
As a result, there are plenty of people like you and me who can be successful investors simply by tracking the index over a long time period.
This is because we can wait out the volatility and let the law of averages strengthen our returns over time.
#4 Don’t Check Your Portfolio Too Frequently
The more often you check your portfolio, the more often you are likely to see losses. This can induce fear and panic about losing money.
When many investors see their portfolio go down they panic sell, which is the worst thing you can do during a stock market correction or bear market. This is one of the most common impacts of behavioural biases.
This might seem obvious, but there is a complex psychology behind this.
“Rationality does not always prevail and when you start seeing your investment value dropping by hundreds and then thousands of pounds it can be hard to sit there and deal with the sinking feeling in your stomach…
We feel the pain of losing what we already have more than we feel pleasure in gains. If acted upon, this natural aversion to loss causes the greatest detriment to investors.”
#5 Consider A Passive Investment Strategy
With investing platforms like ikigai, you can choose the risk level that suits you and the portfolio is automatically managed for you.
This passive approach to investing allows you to avoid all of the negative heuristics, biases and flawed judgements we can see that all investors are naturally exposed to.
It helps you by-pass the majority of decision processes that are required for stock picking strategies, without impeding your returns.
For example, by automating your investing you avoid having to check your portfolio quite as much.
Therefore, when I approach investing, I look for a company like ikigai that offers:
- Professionally managed investment portfolios
- No minimum investment
- Regular rebalancing and reinvesting of dividend
- Low, or zero management fees, you only pay low custody and product fees
- No entry or exit fees
By simplifying all these investing decisions into as few decisions and using a passive approach, investing becomes much less stressful.
All of which will help you to overcome your behavioural biases and build a successful investing strategy.
Join Our Newsletter!
Get content like this in your inbox every Friday
We built ikigai specifically for those who want to bring their lifestyle to the next level, by taking better care of their finances.
ikigai beautifully combines wealth management and everyday banking in one single app. And by doing so, it creates a whole new world of opportunities.
Visit https://ikigai.money to find out more.Maurizio & Edgar, Co-Founders, ikigai
When investing, your capital is at risk.