Five emotional biases to avoid in investing
One thing we talk about a lot is how investing isn’t all about dollars and cents. In reality, it can be an emotional thing.
Some people might invest for their children or their future. Others might invest to support companies they believe in.
Sometimes, emotions can create biases that negatively impact our investment decisions. These biases can be hard to avoid, but if you’re aware of them, you can recognise when you’re letting your emotions drive you into making an investment decision that doesn’t align with your goals. Let’s take a look at some of these biases.
Loss aversion bias
Let’s say that someone comes up to you on the street and gives you $5—that would feel pretty good! Now let’s say that you lose $5 from your wallet—that would feel pretty bad. In fact, it would probably feel worse than the corresponding good feeling of receiving $5.
Humans are hard-wired to feel the pain of loss more intensely than the pleasure of equal gains. This is called loss aversion. Loss aversion can drive investors to:
Sell ‘winning’ investments too soon (investments they’ve made gains on) and give up the potential for any future gains. If you’ve seen an investment gain in value, it’s easy to fret about then losing those gains—and that imagined loss feels much worse than the gain.
Hold onto ‘losing’ investments for too long (investments that aren’t performing well), because selling the investment ‘locks in the loss’, which triggers negative emotions. Say you invest $10 in a company, and after a couple of weeks, it’s worth $8, then $6, then $5. Although these losses can hurt, you may sometimes be better off taking small losses early, rather than waiting to see if they’ll turn around.
Avoiding loss aversion bias
To avoid loss aversion bias, you could set some rules for yourself—for example, not selling until the share price increases by a certain amount, or not hanging onto something once it drops by a certain amount. It’s also useful to try to avoid emotional attachments to investments. Remember, none of your investments are a reflection of you specifically. If something doesn’t work out, that’s okay! You don’t have to hang on, just to justify your original decision.
Overconfidence bias happens when investors have some success investing, and attribute that success to their own decision-making. While this might be true, it could also depend on factors outside of the investor’s control (with the investor overestimating their own abilities).
For example, overconfidence bias is common when share markets are generally trending upwards, and lots of investments are doing well; an investor picks a few investments, gets solid returns, and assumes they have amazing intuition or reasoning. In reality, it’s very hard to consistently pick the exact right investments—even the experts can get it wrong sometimes.
Overconfidence bias can lead to things like:
Underestimating risk, while overestimating the upside of an investment
Not diversifying enough
Excessive buying and selling (as a result of trying to beat the market), resulting in large transaction costs from this buying and selling.
Avoiding overconfidence bias
Talk to people! Seeking out other perspectives is a great way to test your own thinking, and find flaws that you may have missed yourself—you could even speak to a licensed financial adviser.
Over time, make sure to review your past investment decisions, especially in relation to the overall market. Consider how the performance of your portfolio is being driven by movements in the wider market, the amount of risk you're taking, and your decision-making.
With investing, you need the self-control to invest money in the first place, rather than spend it immediately. You also need the self-control to leave that money invested for your intended time horizon (and not dip into it!). It can be easy to be tempted into raiding your investments to spend on things you want today, “just this once” (but it’s never just once).
Lack of self-control can lead to:
Not investing enough money over time to achieve your investment goals
Taking big risks to make up for lost time, in response to not having enough money invested—it could be that these risks aren’t suitable for your financial situation or risk tolerance.
Avoiding self-control bias
One way to avoid self-control bias is to have a clear set of goals, along with a clear plan to meet those goals. This might involve investing the same amount regularly so that it becomes automatic. Make sure to review your investment goals and plan every now and again.
Status quo bias
Status quo bias is the tendency to value existing situations (because they provide comfort) over unfamiliar, possibly better situations. There’s a bit of inertia in here as well—it’s easier and requires less effort to stick with what you’ve been doing than it is to switch to something better.
This is a tricky one because it’s deeply rooted in our brains. It’s a survival instinct from when we were much more primitive than we are today.
This can mean choosing investments that are familiar and comfortable, rather than investments that help you achieve your goals. For example, if you’re used to putting money in the bank, you might invest in a couple of conservative investments. But this approach might not necessarily be the right one for achieving your specific investment goals.
Avoiding status quo bias
By sticking with what you know, you might not be considering other investment options that potentially better suit your investment goals, time horizon, and risk tolerance. Getting out of your comfort zone and learning what else is out there is one way to make sure you’re weighing up what’s best for you! Learning more about risk and return can also help you figure out what’s needed for you to achieve your goals—you could even speak to a licensed financial adviser.
Make sure to review your investments on a regular basis, and check your investments against your goals. Are you sticking with them because they align with your goals and risk tolerance? Or are you sticking with them because you’ve always had them? If the answer is the latter, then it may be time to make some changes to your portfolio.
Regret aversion bias
Regret aversion is when investors get paralysed by the thought of making a bad decision—so they do nothing, or invest in things that don’t match up to their goals (like investing more conservatively than they could be). Regret aversion generally revolves around risk avoidance, which can sacrifice potential opportunities.
Another element to this is herding behaviour, which is when investors follow one another and invest in ‘hype stocks’. The mindset here is that if you make the same mistake everyone else makes, then you won’t experience much regret, because you’re ultimately not to blame.
FOMO (fear of missing out) is part of this too. This is when investors see big gains that other people are making and invest so that they can get in on the party. It’s not driven by any analysis, or consideration of how an investment fits with their goals—but rather, just a fear of regret from being left behind. FOMO can lead to excessive risk-taking as people invest to follow the crowd, without thinking about the implications for their own investment portfolio.
Either way, regret aversion bias can lead to investment decisions that aren't aligned with your risk tolerance, and could impact your ability to meet your investment goals.
Avoiding regret aversion bias
Once again, it’s about clarifying your goals and risk tolerance and investing in things that help you get there. Consider a long-term view of your investments and the impact of not meeting your investment goals (for example, not having enough money for retirement).
Do your due diligence and try to avoid chasing trends (there’s a chance that the trend has already been identified and exploited).
Diversification is key here too, as it helps you spread your risk across your portfolio.
Bottom line: diversify and check in regularly
The bad news about these biases is that they can hinder your investment decision-making processes. It can be hard to tell when you’re being affected by them because your brain has a way of tricking you into thinking you’re making a rational decision.
But here’s the good news: you can manage these biases by setting clear investment goals and understanding your time horizon and risk tolerance, as well as doing your due diligence and diversifying your investments.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.