C: Behavioural biases can lead investors to make decisions that can jeopardize their investments
The traditional economic theory assumes that all individual investors would behave and act rationally by considering all information available to them. This would be reflected in the prices of assets and ultimately, what makes markets efficient.
But we know textbook theories don’t apply in real life and investors do not behave rationally all the time. This is particularly true when markets reach euphoric highs or plunge to scary lows.
Following these mental cues or tendencies can be harmful, especially when logic gets thrown out the window. Decisions that may appear rational are in fact detrimental. Here are four common behavioral biases that can lead investors astray and how one can overcome them.
1. Recency Bias
Symptom: If you find yourself reacting immediately to every breaking headline and being trigger happy with your investments, you may be succumbing to recency bias which is the tendency to overemphasize new information.
In the current 24-hours news cycle with the prevalence of social media, the investment realm has become a global echo chamber constantly reverberating with news alerts.
The coronavirus outbreak and ensuing market correction is a more recent example. But if there is something more contagious than any viral outbreak is the spread of fear. Add a web of disinformation and fake news; you have a toxic concoction oozing with fear and market angst.
If you look at past outbreaks like that of Severe Acute Respiratory Syndrome (SARS) in 2003, the incident didn’t create any long-term impact on asset classes and equity markets promptly recovered after the outbreak was contained.
Having a recency bias will also almost certainly lead you to buy when markets are peaking and selling at the bottom.
Remedy: There is nothing wrong with staying informed with new information, but the problem lies in how we react. According to Lim Chia Wei, a portfolio manager of Affin Hwang Asset Management, it is essential to first recognize the media’s thrives by sensationalizing new news.
“I think it is helpful to clearly write down every investment’s long-term thesis. As new information presents itself, we should ask ourselves how the new information will affect our long-term thesis. It is crucial to think in terms of probability. Anything is possible to break or support one’s thesis. But not everything is probable,” he says.
The prevalence of market noise as well as the legitimisation of social media as a reliable news source has injected more volatility in markets. Think US President Donald Trump and his Twitter diplomacy during the US-China trade talks last year. If you reacted to every one of his tweet, you may find yourself burnt in the end by Trump’s randomness.
2. Herding Bias
Symptom: There is safety in numbers, correct? Well not really if you look through history. From Tulipmania in the 17th century, the dotcom bubble in the early 2000s, and the 2008 subprime mortgage crisis, history has shown that investors are willing to suspend disbelief when the going gets good. But, we all know how the story ends when there is irrational exuberance bubbling amongst asset classes.
Investors are social creatures, and we are comforted that someone else is buying into a particular investment too. But the wisdom of the crowd can be wrong and the repercussions severe. More recent examples like the bitcoin mania underscore the dangers of herding behavior.
The truth is much of today’s market volatility is also fuelled by machines or algo-traders that profit from short-term fluctuation in prices and ignore any fundamental analysis. Behind each market plunge is a digital herd of trading bots programmed to buy and sell based on pre-determined formulas and models.
This ignited a ‘flash crash’ like that seen in 2010 when the Dow Jones Index lost close to 1,000 points in mere minutes. The S&P 500, Dow Jones Industrial Average and Nasdaq collectively lost US$1 trillion. But in 36 minutes, the rout was over and markets rapidly recouped its losses.
Remedy: Stop focusing on what the crowd is doing. Instead, work on developing a plan that is right for you. Understanding the self is the first step in modeling a portfolio that is meant to serve your life goals and financial aspirations.
Next, concentrate efforts on building a diversified portfolio that fits your own financial goals and risk-appetite. Intraday fluctuations in markets are unlikely to bother you if you are well diversified across asset classes.
A diversified multi-asset portfolio with low correlations helps smoothen the investment journey when faced with adverse market conditions. In turn, this would induce investors to stay invested and reap the benefits when markets bounce back.
3. Loss aversion bias
Symptom: We all hate to lose money. But if you find that fear of loss crippling and clouding your decision-making, you may be suffering from loss aversion bias. Investors often feel more acutely the pain of loss than the pleasure they reap from gains.
Why are we so afraid of loss? It’s an emotive response that is typically hard-wired into someone’s psyche. In markets, this is manifested through behaviors of extreme risk-avoidance, such as investing in only low-risk, low-return investments and selling immediately at the first sign of a headwind.
This behaviour is counterproductive to investors’ financial goals by not fully utilising their capacity for risk and financial resources.
Remedy: Investors’ memories are by nature short-term and most of the time we only remember the bad parts. If you are feeling jittery about markets, consider rebalancing your portfolio to its target asset allocation or locking-in gains to raise some cash.
Importantly, work on developing a financial plan that suits your goals and risk-appetite. If you cannot stomach the volatility, chances are that you may be taking too much risk and there is a portfolio mismatch.
Chia Wei believes it is important to have the right perspective of performance to overcome one’s loss aversion bias. “History has shown that taking a long-term investment approach and sitting through short-term declines has been very rewarding. Investors should push themselves to focus on the long-term prospects and de-emphasise short-term events.”
4. Confirmation bias
Symptom: One of the more common behavioral biases amongst investors stems mainly from overconfidence, particularly in bullish market conditions. When investors are misled to think they are invisible in the marketplace when they are raking it in, this can lead to tunnel vision when they only seek out information that supports or confirm their view.
For example, say you just added a new stock into your portfolio. When you continue your research on the stock, you only click on positive headlines which support your decision but avoid negative ones. Restricting yourself to such information only confirms your own assumptions that may lead you to miss important red flags or warning signs.
Remedy: Be open to new sources of information that may not sit well with you. Ask yourself if the issues raised have their merits and if they would impact the fundamentals of a particular investment you just made. It’s not easy to challenge your own assumptions. Still, it is important to do so, especially when there is a lot of hype built-in and technical indicators are pointing to overbought territory.
Investing With Clarity
The first step in overcoming behavioural biases is to understand why we have such tendencies in the first place. But proper planning with clear financial goals can help anchor investors and guide them in their financial journey no matter how markets behave.
Stick to a disciplined approach by investing consistently and be conscious about the decisions you make to navigate markets confidently.
About the Author
Lee Sheung Un is a communications officer at Affin Hwang Asset Management. A millennial, he is still finding that balance between wealth, freedom and purpose. Views expressed are his own.