Investment decisions are no exception as they reflect personal behavior.
Behavioural finance attempts to understand why investors make decisions the way they do, and makes the key assumption that not all investors are rational. Most investors tend to make investments decisions derived from individual feelings, perceptions, past experiences, information from peers or just out of greed or fear.
Common behavioural biases
Loss Aversion: Probably one of the most common biases where investors accept gains more easily as compared to losses. Investors with this bias tend not to take acceptable risks on a given asset based on their fear of making a loss, especially if they had encountered similar experience in the past.
Herd mentality: If you’ve been in a situation where you bought a security or did a currency trade just because you felt everyone else was doing that, you’re not alone. Herd mentality is more common than you think. The risk of this is that investors end up purchasing high valued assets too late in the day and end up staring down a price cliff.
Confirmation bias: This refers to investors that adopt a one-sided decision making process wherein they are selective, and only pay attention to news that support their decisions. An example is an investor continuing to buy a security irrespective of the negative news and price fall.
Overconfidence: This is a prevalent issue where investors overestimate their ability to predict market movements and become over-optimistic about a security or asset. As a result, they may “overtrade” to align their portfolio based on their perception of the market, leading to incurring excessive costs and concentrated positions in a single security or asset.
Breaking the cycle
Keeping emotions out of the way when making investment decisions is easier said than done. However, there are ways to help overcome behavioural biases.
The first step is identifying blind spots. Even the most experienced of investors and fund managers have biases, so a good starting point is knowing what they are. Once you do, you can tweak your decision making process to “adjust” for the potential impact of behavioural biases.
Try to take the time to read and pay attention to factual information and make it a point to distinguish opinions from facts. Take into consideration both positive and negative facts for securities or assets that you hold or are planning to invest into. If you are basing your decision on an opinion, like a research report which contains investment views, make it a point to understand the assumptions behind the views. If the assumptions doesn’t materialise, it is important to review your portfolio and take timely actions.
Another way to circumvent potential pitfalls of biases is to adopt a portfolio approach when it comes to investments. Diversifying assets to include a good, but not necessarily equal, mix of assets will help to overcome loss aversion wherein an investor may be reluctant to invest in asset classes based on past experience.
And finally, regularly review your investment portfolio. This will allow you to go over your investment objectives and the suitability of the underlying investments, including assumptions that were made based on certain opinions or conditions which may not have materialised over time.
Although it might not be possible to remove behavioural biases entirely, understanding how you as an investor, and markets behave and adopting good habits to promote objectivity can help you achieve your desired investment objectives.
A contribution piece by Deepak Khanna, Head of Wealth Development, HSBC Bank (Singapore), first published in LianHe ZaoBao (in Simplified Chinese) on 13 January 2019.