Aug 15, 2023  | Tags: psychology, investing, risk

Our insights

Most investors understand the basic principles of successful investing.

These include setting your investment goals, determining your appetite for risk which should be heavily influenced by your time horizons, and diversifying your portfolio to minimise losses in the event that one investment or sector suffers a significant downturn.

But there is another factor that influences the investment decisions each and every one of us makes.

Seth A. Klarman, author of the 1990 book Margin of Safety which examines investment strategies, noted, “Investing is the intersection of economics and psychology.”

Successful investing demands a wealth of reliable information, analysed with strategic, crystal clear thinking.

There is no room for irrational or emotive behaviour.

But our psychology, our emotions and cognitive biases, can lead us to making poor investment decisions and even steer us toward the road to ruin.

Simply understanding these biases exist and what yours are can help guard against making expensive mistakes.

Emotional influences

Human beings are emotional creatures who gain gratification from realising their wants and desires.

In the world of investment, that desire is wealth.

But there are numerous emotional influences which can drive investors down the wrong path.

Fear and greed 

These are both irrational emotions that may trigger investors to make mistakes even when they know that long-term investing protects them against short-term market fluctuations.

A sudden downturn in the market may trigger investors to sell for fear of hefty losses but in doing so, they may crystallise those losses and miss out on significant gains when the market recovers.

Greed may tempt investors to buy a surging asset in a market bubble, even though it may be high-risk and have already enjoyed most of its gains.

Overconfidence 

When investors become overconfident, their assessment of an asset becomes skewed. They tend to underestimate the risks and overestimate potential returns.

This can then lead to putting too many of their eggs in one basket, leaving their portfolio at risk due to under-diversification.

Loss aversion 

There is a theory in investing is that you should always sell a stock if it loses X per cent of the price you paid for it.

But many investors are reluctant to do this because selling solidifies that loss and they feel the agony of these losses more than the satisfaction of gains.

Hence, as an example, they tend to hold a plummeting stock even longer, potentially suffering much heavier losses.

Whether weighing up to hold or sell, some investors (especially those who don’t have a clear strategy) fail to consider the influence of time in the market - for example, getting spooked by what’s happening today instead of playing the long game.         

Herd-like behaviour 

Investing isn’t a team sport. Yet many investors like following a crowd, assuming others must know more than they do.

This can lead to market bubbles and inflated values which are rarely sustained.

Warren Buffett advised there is much more money to be made by swimming against the tide: “Be fearful when others are greedy and greedy when others are fearful”.

Cognitive biases

Strong, reliable information is only useful if analysed well.

Cognitive biases can lead investors to arrive at decisions that contradict the data at hand.

Confirmation bias 

Like many researchers, investors often seek information that confirms their pre-existing beliefs, while at the same time ignoring contradictory evidence. This makes objective decision making impossible and can lead to poor investment choices.

Anchoring 

This is an investor’s inability to change their opinion on an investment, despite new information coming to hand. Instead, they remain “anchored” to it.

Their assessment of a stock may be tied to its purchase price and they may hold that stock longer than they should, hoping it recovers its value, rather than critically assessing new factors in play that make that likelihood remote.

Availability bias 

This is when investors make decisions based on their recollection of events or stories that have impacted them and how readily they come to mind.

This can lead to an unrealistic perception of the likelihood of certain events.

Using behavioural science to improve investment decisions

To be emotional is human. But to ignore how it can influence our ability to make sound investment decisions is just plain stupid.

Here’s how you can help take the emotion out of investing.

Education and awareness 

Simply knowing and acknowledging that we all have emotional and cognitive biases is the first step towards limiting their impact.

Set clear investment goals 

One of the basic principles of investing, adhering to this despite your emotional biases will curtail your chances of being seduced by market volatility and help protect your portfolio.

Diversification 

Another basic principle of investing, diversification protects a portfolio from significant losses as a result of market fluctuations. Asset allocation strategies based on your time horizon, risk tolerance and financial goals lead to sound investment decisions.

Seek professional advice 

Working with a financial advisor who can offer an objective second opinion about the merits of your investment choices is the best way to ensure you have not been led by your emotional or cognitive biases.

Get advice today

No matter how sharp and analytical our brain, it is always a challenge not to be swayed by emotional and cognitive biases.

Acknowledging that they exist plays a big factor in mitigating their influence.

But there is no substitute for the discerning, sage and objective advice of an experienced financial adviser.

That’s where Calder Wealth Management can help.

CWM are financial experts who can help you make the best financial decisions now and going forward.

We’ll work with you to devise investment strategies whatever your financial goals.

No-one should do without quality financial advice from someone personally invested in their wealth accumulation.

At CWM, we pride ourselves on leading our clients into the future with structure, financial stability and confidence. 

Contact us today to discuss all of your financial needs and concerns.

Written by Ben Calder

The information contained in this article is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.

Taxation, legal and other matters referred to on this website are of a general nature only and are based on Calder Wealth Management’s interpretation of laws existing at the time and should not be relied upon in place of appropriate professional advice. Those laws may change from time to time.

Calder specialises in wealth management with a focus on advice, investment, sustainability, insurance and finance.