Why your head needs to rule your heart when it comes to your financial future

This is an article about behavioural biases and investment decision-making. If you think that sounds a bit dry and technical, let us start it off with a drink.

Getting your investment tips over a drink

The pandemic is over, and you are meeting an old work colleague for a drink. They start telling you about an article they recently read about a company that designs and manufactures mechanical tools.

“They’ve just announced some really big developments. I reckon the company is going to take off and the share price will rocket”, they tell you. “They’ve just been listed on the Alternative Investment Market (AIM) and the share value has gone up 15% in a month. You really need to get in on it.”

You know your investment platform allows you to invest in AIM stocks, so you’re interested.

“That sounds tempting. I might put a couple of thousand in,” you say.

“A couple? Is that all? This is a huge opportunity! I reckon we’re talking five-figure sum investments. Two of my mates at work are putting in £25,000 each!”

15% in a month is impressive. You pull out your iPhone and start logging on to your investment account…

Let’s stop there. Other than the issue of following trends, which I’ve spoken about recently, there are more fundamental reasons to pause.

What are “behavioural biases”?

In simple terms, behavioural biases are shortcuts that you’ll use when you’re called upon to make a decision. Often, we call them “gut instincts”, or your first reaction to something.

One of the most researched areas, in terms of the impact of behavioural biases, is in investing. They can impact not only the planning stage but the investments you choose and the risk you are willing to accept to achieve your ambitions.

Let me take three examples of behavioural biases. In each case, I’ll refer back to the original scenario to illustrate.

Herding bias

This is where you’re convinced a certain action is the right one, because everyone else is doing it.

In the example above, not only is your mate investing heavily, but two of his work colleagues are as well. You don’t want to be the one who misses out.

Attentional bias

This is where you focus on one or two factors when you make an investment decision, rather than researching more widely.

So, the facts you consider are:

• The company has announced big developments
• There has been 15% growth in one month.

You haven’t done any further thinking or research, so your entire decision is based on just a couple of factors.

Anchoring bias

This is where you take a decision based on the first piece of information you hear.

You’ve heard there will be a 15% return. Compared to the 0.1% you’re getting on your savings account, this sounds fantastic!

But what if the share price of the company’s main rival went up 30% in the last month? How would you feel then?

The 15% you’ve heard has provided the “anchor” to which your future decisions are made. It’s stuck in your mind, and that’s what has driven you to pull out your phone and start dealing.

Behavioural biases and your investment decisions

If you’re looking to generate a good long-term return, then you generally need to be prepared to take some risks. A good portfolio will remain balanced and diversified while still reflecting your aspirations, and your attitude to investment risk.

After all, a “no risk whatsoever” investment portfolio would typically result in a savings account with extremely low interest rates. (A point here: if your savings are not keeping up with rises in the cost of living, and so are losing value in real terms, is this not a “risk” in itself?)

If you start making a habit of snap investment decisions based on emotional reactions, then it’s very likely that you could severely damage your chances of reaching your long-term objectives.

The key factor is to be aware that biases exist. If you accept that, then it makes your reactions easier to manage.

Download my fascinating free guide to read more about behavioural biases and investment decisions.

Let’s take another scenario to illustrate our point about biases and snap decisions.

Dow Jones and the pandemic

On 21 February 2020, the Dow Jones index was at a record high of 29,992. Three weeks later it had lost 20% of its value as the impact of the Covid-19 pandemic caused markets to fall all over the world.

With no idea of the potential bottom of the market, many would have followed the herd – “herding bias” – and panicked and sold up, taking the 20% hit to their investment values.

Less than a fortnight later, with the Dow Jones down a further 14%, that decision would have seemed to be the right one.

Clearly many more people were exhibiting herding bias and following others. I suspect there was probably something called “confirmation bias” in there too. All the press talk was about the market crash, so a preconceived idea that “I should sell up”, would have appeared justifiable.

Now, however, the Dow Jones has made a full recovery, and is up 13% from its former high last year.

Sometimes ignoring your biases and doing nothing at all is the best thing to do.

Avoiding costly investment errors

So, what should you have done when your mate told you about those shares?

Firstly, it’s vital you ensure that any decision you make is in line with your overall investment plan.

Then, it’s important not to react immediately. Remember that behavioural biases exist, and don’t let them influence your decision-making. Do some research into the company yourself. Read the opinions of some independent investment analysts you trust. Let the dust settle and see if you feel the same a couple of days later.

Finally, and most importantly, have a filter set up to control your investment behaviour and prevent you making snap judgements you might regret.

This is where I come in.

When it comes to investment decision-making, the role of a financial planner becomes crucial. I’ll become your second pair of eyes – validating and questioning your decisions.

At the outset, I’ll work with you to develop a long-term investment plan, based on your aspirations and objectives. I’ll then be your sounding board, helping you to keep on track to reach your goals through regular reviews and changes.

By taking these steps, and managing your investments in this way, we can minimise the negative impact of behavioural biases. You may still be able to invest based on a tip from a mate, but such a decision will be based on empirical evidence and research, rather than the fact that two of his work colleagues think it is a sound investment.

To find out more about how behavioural biases can impact on your investment decisions, and how I can help you with your investment decision making, please give me a call on 07769 156 250.

Please note

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

 

Foster Denovo Limited is authorised and regulated by the Financial Conduct Authority.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.