Behavourial biases – Knowing the pitfalls of investing

It’s the most overly used work in finance; buying low and selling high. It seems simple enough, yet it might turn out to be easier said than done.

Behavioural biases affect the way we analyse and make decisions. Making the wrong judgement purely based on your cognitive biases can be costly.

It is almost impossible to be free of biases in all our decisions. After all, we are merely humans. Nevertheless, by understanding what they are will go a long way towards helping us make better decisions. Here are the three most common biases that may affect your investing performance:

 

Recency Bias

This is the pitfall that most investors fall into. It is one of the main reasons why they keep chasing up a certain stock or asset class – believing that the current situation or trend will continue into the future.

Recall the gold run from 2009 to 2011? Prices were increasing and the general notion was: If you don’t buy the yellow metal now, you will only ever going to buy it at a higher price. Gold prices breached 1800 at its peak in 2011, but it was all down-hill from there. At its lowest point in 2016, it touched the 1,060 levels.

Taking another example, will you invest in stocks/equities during a recession? The majority of people will not. From what they see, share prices are falling, times are tough and that’s likely to remain so for the foreseeable future.

Simply put, if the market is good and the air is filled with optimism, it’s not unusual to see some pretty bullish and mind-boggling forecasts by the investing community.

Conversely, as soon as the markets turn bearish, one by one, the doom and gloom reports will come streaming in – the next prediction even more bearish than the one before.

In short, investors tend to extrapolate the current returns or price direction or market trends and expect more of less the same to continue, which may not be the case. For instance, markets turn fairly quickly and investing during a market down-turn can turn out to be a rewarding decision.

 

Herd Behaviour

Have you bought or invested in something because your friends bought it? Maybe you read about an investment fad in the Internet, and before you know it, most of the people you know have seemingly subscribed to that belief. You decide to jump in and hop on the bandwagon.

The early bird gets the worm. After all, the people bandying it are experts, if it’s not good there won’t be anyone buying the idea. How can the combined wisdom of so many people be wrong? Well, they can be wrong, and you will be too if you don’t conduct your own research and homework.

Herd behaviour is one of the main causes why asset bubbles are formed eg: the Tulip Mania in the 1630s

 

Confirmation Bias

Have you ever so staunchly defended a thought or an idea? You brush aside all other information that does not conform to your own set of thinking; whether consciously or unconsciously.

On the other hand, any articles or ideas that relate to your same train of thought only serves to justify and strengthen your belief in a particular idea.

Yes, that is your brain being clouded by confirmation bias, which explains why we tend to actively seek out information which confirms to our existing view. We like to think that we are able to evaluate all facts and data. Our brain filters out information in a selective way.

We prefer to listen to stories from people deemed as ‘professionals’ rather than analyse cold hard facts and numbers. We have a knack of jumping to our own conclusion

Try drawing from multiple sources of information with an open mind, especially the ones which contradict your views.

 

Conclusion

These are merely three of the traits which we talked about in this article, with a longer list yet in the study on behavioural finance. It’s definitely not easy trying to deal with these biases as they are inherently human nature. However, it will be a major step forward now that you are aware of these biases. Keeping in mind the existence of behavioural biases is crucial in your next investment decision-making process. Here’s a two-step process:

First, conduct a self-check, before you press the ‘sell’ or ‘buy’ button. Think again – are you making this decision partly driven by your emotions? Are you following an expert or a friend who said this? Are you extrapolating the good returns and expect the same to continue into the future?

Second, know the reasons why you have made any particular judgement.

If your friends recommend a stock that has already gone up by 100 per cent this year and expect another 100 per cent, ask yourself these relevant questions. How do you think the particular stock can produce another 100 per cent in return even after it has already achieved an extaordinary gain this year?

What is the company doing differently from the rest out there in the market to justify another doubling of its price? Is the stock’s fundamentals backed up by actual earnings or is fuelled by rumours and speculation.

Investing rationally requires you to give weight to facts and data, and an objective analysis of market information.

 

Areca Capital is a niche Malaysian fund management company. We are a firm believer in the advisory-based approach towards investing. We help our clients, who range from individuals to corporates, family and private trusts, foundations and other institution to achieve consistent risk-adjusted returns over the long term. For any enquiries, you may contact us at 03-79563111 or by email: invest@arecacapital.com.

Disclaimer: The article is produced based on material and information compiled from reliable sources at the time of writing. The article is not an offer, recommendation or advice to transact in any investment products, including the stocks or funds mentioned within. Investors are advised to consult professional investment advisers before making any investment decision.

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