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Emotional Investing
Emotional Biases
If we consider the definition of a bias; a bias is a statistical error or preference caused by systematically favouring some outcomes over others. Emotional biases then stem from impulse or intuition, arising spontaneously because of attitudes and feelings that can cause decisions to deviate from the rational decisions of traditional finance.
Emotional biases typically lead to impulsive decision-making or reactive behaviour, which can lead to poor financial decision-making. This can result in an outcome that might have been avoided, if the decision had been made considering further research, objectives and timeframes.
As emotional biases often stem from personal and sometimes unreasoned judgements, they are less easily corrected.
An individual may wish to control their emotions, but often they simply cannot. Therefore, it may only be possible to recognise an emotional bias and “adapt" to it.
The main emotional biases we will explore in this article are as follows:
- Loss-aversion
- Self-Control
- Status quo
- Endowment
- Regret aversion
We will have a look at each of these in turn below. You will no doubt appreciate that these emotional biases are common indeed and may even affect those of us who try our best to be more rational.
Loss-aversion
None of us like to lose something that is important to us; this is pretty obvious. It is quite normal to fear loss, but loss aversion is more than that. With this bias, we as individuals are conditioned to react more keenly to a loss than to an equal but opposite gain. In other words, if we invest £10,000 into two shares and these change to £5,000 and £15,000 respectively, we are more likely to look at selling the £15,000 share and holding the “loser” to try to get back to even money, even if the poor-performing share has little chance of getting back to its starting level.
This phenomenon can be partially mitigated by considering what you would do if you had the cash value of the share and had to choose whether to buy that share again, buy something else or stay in cash. Such an exercise is aided by looking at the fundamentals of that asset (gathering as much hard data as possible to avoid a cognitive bias from replacing the emotional one). This re-framing of the problem can lead to positive insights in many situations, though it is by no means a panacea for this bias.
Self-Control
We have all had impulses to do something that, rationally, we know is a bad idea. When it comes to investing, this can manifest in a couple of obvious ways. In the first, you may chase after an investment strategy that appeals for reasons which aren’t entirely rational. For example, you may choose to put 100% of your portfolio into an extremely high-risk strategy which could go spectacularly wrong. In most cases this strategy is not a good idea, but the appeal of those high returns can be difficult to resist. Applying a sound investment approach will help address this issue.
Secondly, it may be that life gets in the way of funding investments. Rationally we all know that putting money aside for the future is sensible, but we are also tempted to splash out from time to time, and that can ultimately lead to problems if self-control is frequently lost. The ability to set up regular contributions can help with this, as regular contributions then form part of normal expenditure. Managed appropriately, this results in investments building over time, with surplus cash left over for whatever impulses take our fancy.
Status quo
As humans, we like our comfort zones. Once we establish a routine it can be very difficult to change, and this is no different when it comes to investment decisions. Remaining in a long-standing strategy can feel comforting even if the world has moved on and the strategy itself is no longer sound.
This can also have an impact on risk exposure. Portfolios set up initially will almost certainly have winners and losers, some investments growing fast and others slower, or even falling in value. Left alone for long enough, the higher-growing investments will increase their influence over the portfolio by growing more, and if the status quo is maintained this will result in a significant increase to the overall risk to a portfolio over time, assuming the higher-risk investments generally result in higher returns.
Dealing with this requires some discipline, both in terms of a suitable rebalancing strategy, whereby you regularly review and if needed, update your portfolio, and a changing target asset allocation as time passes and circumstances change.
Endowment
When we buy investments, we usually hope for some element of growth on that holding (the exception being high-income investments which might stand still). This is generally with good reason, but if you suffer from Endowment bias, you might instead assume that the simple nature of you owning an asset or investment increases the value of that asset.
Within traditional economics, value is simply what the market is willing to offer, and investors should broadly be happy to either buy or sell at the exact same price depending on their need for either capital or investment growth.
This becomes particularly relevant with inherited assets, where an intangible sentimental value may be ascribed to investments that previously belonged to a loved one. Unlike many other emotional biases, this does not have an easy solution, and sometimes the only solution is to simply grit one’s teeth and order the sale, reinvesting the funds. It could be helpful to do so with a goal in mind that honours the memory of your loved one.
Regret Aversion
Somewhat similar in appearance to Status Quo, Regret Aversion is an emotional bias which can prevent effective decision-making. In this case, however, rather than being stuck in a comfort zone, the individual is so focused on possible negative outcomes of their decision that they choose poorly.
As regret is a powerless and discomforting cognitive and emotional state, people tend to make decisions in order to avoid this outcome, that is to avoid regretting an alternative decision in the future.
This can result in either joining a trend or investing in an asset because other people are doing so, without necessarily having conducted any research or understanding the benefits or more importantly the disadvantages of a particular investment, which may then counteract the fear of missing out. . This can also result in selling an investment in a falling market due to the fear of losing even more and therefore regretting not having taken any action.
With investments, typically losses are not incurred if an investment has not been sold and therefore the loss itself has not been realised. In falling markets, the best course of action is to sit tight and wait for conditions to improve so these can recover. To remain calm when things are not going well and not to react will always be challenging for both first-time and seasoned investors as it is counter intuitive.
This can be addressed with a sound investment strategy selected by a trusted third-party, as this should take any risk of being over- or under-exposed to risk out of the equation and reduce the decision to a simple “yes or no” question.
Is There a Better Way?
The common theme across emotional biases is the need for a sound investment strategy, good discipline and making decisions based on all available information. Our in-house investment strategies all meet these requirements, setting up a solid investment strategy tailored to client requirements.
Our analysts track markets and economic conditions and recommend suitable reactions regularly, taking the emotional biases and cognitive errors out of the equation for you.
If you would like to learn more about how we can help you why not get in touch and speak to one of our expert advisers for an initial consultation.
Please note: Past performance is no guarantee of future returns. The value of investments and the income from them can fall as well as rise, you may not get back what you originally invested.
