By now, most of our readers will be more than used to our core investment beliefs of staying calm, riding out volatility, and the fact that markets will rise over the long term, but there is more to it than that. We always say ‘don’t panic’ but in reality what we mean is don’t let your emotions drive poor investment decisions that could lead to a change of outcomes in the long term. Feeling uneasy is very normal in itself, especially when it comes to investing. For many years it has been the fascination of scientists and we now have a considerable amount of data on the subject of behavioural finance.
Behavioural finance studies how people react to certain events and, more importantly, why they react this way. The following blog looks at some of the key behavioural biases and why these may cause you to feel uneasy in times of market volatility.
Loss Aversion
Loss Aversion is based on the theory that humans feel twice as much pain when it comes to a loss compared to the equivalent gain. Put very simply, this means that if you had £100 and you lost £10, you would feel twice as bad compared to if you had gained £10. Or to cancel out the pain with happiness you would need to gain £20 for every £10 loss.
This is one of the core reasons that stock market drops can cause such panic. A 10% sudden drop in an investment market can happen very quickly but the equivalent feeling of a sudden 20% gain is less common and typically happens over a longer period.
Herd Mentality
Herd mentality can be seen across various aspects of day-to-day life and is built on the premise that people find reassurance and comfort by following a belief or behaviour that many others are also following.
In investing, Herd Mentality can lead to bubbles, either in individual stocks, such as GameStop or even in the market as a whole, such as the Dot-Com bubble back at the turn of the century.
It is important to be aware that even if it seems the majority of investors are turning to a particular asset, this does not necessarily mean that you should follow the herd.
Confirmation Bias
Confirmation bias goes very nicely alongside Herd Mentality. Confirmation bias relates to the tendency for humans to seek out pieces of information that back up their pre-existing beliefs or viewpoints.
This is not helped by some people’s poor use of search engines these days. What you type into Google can vastly change the results you receive. For example, the difference between asking Google if a share is good to buy versus asking if you should sell the same share can show vastly different results.
Again, as with all of these biases, awareness is what is crucial. It is important to research any topic with an open mind and not just seek approval for your current way of thinking.
Anchoring Bias
The basics of Anchoring Bias is that humans tend to latch on to something, such as a number, and anchor themselves to this. For example, many investors lately will have anchored themselves to record-breaking highs in the stock markets during mid-February this year. This meant that when investors saw stock markets drop over the following 6 weeks, these losses felt considerable.
In reality, anyone who cared to look further out would have noticed that the majority of portfolios will still be showing positive 12-month gains, and three and five-year investment returns have been very healthy. It is this anchoring bias that can lead to investors panicking over the short term.
Conclusion
It is crucial to remember that these biases are very normal. Countless numbers of studies have been conducted with members of the public from all walks of life with various levels of education and the vast majority will conform to the above biases to some degree. One of the most famous tests was conducted by Solomon Asch in 1951. He gave several groups of 8 participants an easy problem. He showed them three lines of various lengths and asked them to identify which line was closest in length to a target line. 99% of participants, when asked individually, were able to identify the correct line, however, when placed into groups of 8, 7 of the participants were in on the study and were told to pick a certain incorrect answer. This led to over a third of the individuals picking the wrong answer after they were ‘swayed’ by the other 7 participants giving what was clearly an incorrect answer. Herd mentality at its finest.
In summary, we believe that it is important to be aware of these behavioural biases. These are basic human instincts that are normal behaviour traits in people. This blog is not intended to try and alter people’s core human instincts but, instead, we believe that if you can understand a bit more about why you feel what you are feeling, it helps to make more rational choices moving forward and remember, it is an incredibly normal human instinct to worry when markets drop.
We constantly keep our investments under review and stay on top of what’s happening in markets so you don’t have to. We will contact you if we think you should take any action, that said, we’re always here if you’d like to speak.
Footnotes
None of the above should be treated as advice.
