The psychology behind investing
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Pandemic. War. Supply-chain issues. Rising inflation/interest rates. Share market volatility. Bond price declines.
An initial reaction may be fear for our nest eggs during this time. However, it’s important to recognise why we feel this way and learn to overcome the biases that influence financial decision-making during such periods.
Our brains tend to make decisions influenced by our emotions, taking mental shortcuts to reach conclusions efficiently. Unfortunately, this can lead to poor decisions, such as selling investments at a low due to fear or buying investments at a high due to FOMO (fear of missing out).
When we have this emotional awareness, the next step is exploring one’s own behavioural biases.
Common biases to look out for are summarised below:
|
Bias |
Explanation | Example |
|
Loss Aversion |
An individual holds a strong preference for avoiding losses as opposed to achieving gains. |
Not losing $10,000 is more important than gaining $10,000. Unfortunately, this can lead to investing too conservatively. |
|
Recency |
Too much focus is placed on recent events. |
Starting with an initial investment of $100,000 that grows to $170,000 over time but suddenly drops to $150,000. An individual focuses on the recent fall of $20,000 rather than the longer-term gain of $50,000. |
| Overconfidence | The unwarranted belief an individual has in their knowledge and judgement. | An individual who believes they can time the market i.e. attempting to buy low and sell high. When in fact, it is doubtful they can do so. |
So, besides being aware of these biases, how can we better manage them?
For loss aversion bias, my view is to remove emotion from investing. Don’t look at your investments too often (especially during volatile periods), ignore the media’s sensationalism, and put the loss into perspective, e.g. using historical data. What’s the likely worst-case scenario for my specific portfolio?
For recency bias, consider the bigger picture. The ASX All Ordinaries fell from 7,237 to 4,564 in a month in early 2020. It then recovered relatively quickly and more currently sat at 7,339 (as at 17 November 2022). Panicking over short-term falls in value can lead to loss. Realising these short-term falls are a natural part of investing, being patient, and focusing on the long-term generally produces significantly better outcomes.
According to Vanguard the average bull market lasts for 852 days versus the average bear market, which lasts for 236 days* highlighting the importance of long-term investing.
For overconfidence bias, seek more information and the opinions of others, especially viewpoints that counter your own. For example, do I have real reasons confirming I know more than others in the market?
Arming yourself with this knowledge can mitigate disastrous decisions while keeping you on the right path.
As Benjamin Graham once said, “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game."
Tim Johnson
Financial Advisor
Beyond Bank Australia
