The secret to successful investing: control your emotions

Traditional economic and market theory suggests that people act rationally and consider all available information, which results in optimal outcomes and an efficient market. The concept of behavioural finance, and in particular behavioural biases, challenges this hypothesis by incorporating research on how individuals and markets actually behave. 

By understanding these biases, we can improve investment decision-making, both by mitigating them in ourselves and recognising them in others.

Have you ever become emotionally attached to a stock that you own? 

The investor with endowment bias places a higher value on investments that they own, than ones they do not. This causes them to hold on for too long. Imagine that you did not own the stock… would you buy it today? If not, you should not be holding it.

Do you place more weight on views that you agree with? 

The investor with confirmation bias has a tendency to seek out information that confirms their existing views, and disregard information that challenges it. Before making an investment, try and understand the views of those who are selling it. 

Have you ever held on to an investment because it is at a loss? 

The investor with loss aversion bias holds on to an investment because it has a loss which they cannot stomach to turn from a paper loss, which may recover, to a permanent loss. If there is a better opportunity, they should sell the investment and re-invest, regardless of the history of their personal investment. 

Have you ever sold an investment because of a sharp fall in its share price? 

When the investor with information bias sees a fall in the share price as a result of news headlines or adverse economic forecasts, they panic and sell their shares. Investors are fed a vast amount of useless information by newspapers and economic commentators, particularly when it comes to short term economic data, and it is important to look through the noise and concentrate on what really matters.

Do you take credit for predicting past events, while putting poor investment decisions down to market volatility or unexpected shocks? 

The investor with hindsight bias will not learn from their mistakes. Investment decisions and the investment thesis should be documented and periodically re-assessed. 

Do you know anyone whose belief in their own ability to make investment decisions is higher than reality?

The investor with overconfidence bias places more weight on their successful investments than their unsuccessful investments, which they often forget about. This bias means they (you?) will not learn from their mistakes.

The investor with status quo bias finds it easier to do nothing. Humans are creatures of habit. Don’t get stuck in your ways.

Do you have a tendency to overstate your ability to show restraint? 

The investor with restraint bias lets greed and temptation lead to oversize bets in their best ideas, particularly when they think they have identified a sure winner. Do not ignore probability. Accept that you may be wrong and size an investment properly.

Have you ever made an investment because the price is lower than it was? Or sold an investment because it’s gone up a lot? 

The investor with anchoring bias places too much emphasis on a reference point. An obvious anchor is the recent or current share price. When valuing an investment, do not rely too heavily on current share price or recent share price movements, for it contains very little information about the intrinsic value of an investment. Use your own analysis to estimate the intrinsic value of an investment and then compare it to the current share price. 

 

These biases are often subconscious. It is not enough merely to be aware of them. Investors must actively search for them within their decisions and put a process in place to mitigate their own biases. The prevalence of these biases among market participants partially explains why markets are not efficient and presents an opportunity to the active investor who can recognise where share prices have become dislocated from intrinsic value.