When it comes to the many decisions we need to make throughout the day, the human brain likes to make things as easy as possible. Using mental short-cuts – or biases – to quickly work out simple answers to complex problems is one way of doing this.
Problem is, although a mental short cut – or even a physical one for that matter – can come in handy when dodging a sabre-tooth tiger, mental biases can lead us astray and impair our judgement when it comes to making more difficult decisions. And in the context of investment, they could just be costing you money. Think miss-timing the market, selling assets when we should hold your nerve, and buying assets on impulse, rather than after careful analysis. So how do you avoid the pitfalls of mental biases? Being aware of them is a good first step.
Three common mental short-cuts that could be influencing your investment decisions
- Anchoring – Also known as the ‘relativity trap’, this is the common tendency to rely too heavily on one item of information (or anchor) when making an investment decision. The anchor can be something we know from the past, such as the price paid for a share, or the gain achieved from a similar investment.
If you buy a parcel of NAB shares when they are priced at $26, most investors will ‘anchor’ their views about ‘value’ at that price, regardless of any subsequent information or price action for NAB shares. This makes it difficult to analyse the current investment situation logically and decide whether to sell your shares independent of the previous price, or gains achieved.
- Loss aversion – Extensive behavioural finance research has shown most of us feel more satisfaction from avoiding a loss than acquiring a similar gain. This leads us to unconsciously make decisions based on the pain we believe we will feel if we lose money.
Anna purchased a parcel of shares in a major Australian retailer three years ago when the price was $15.67. Although the price rose for the first year, since then the retailer has experienced tough times, with consumers increasingly unwilling to spend and profits falling.
The current price for Anna’s shares has drifted down to $12.89 and consumer sentiment is showing no sign of improving. Many share analysts are predicting Australian share prices are facing downward pressure.
Despite this, Anna is unwilling to sell and lose money relative to the price she initially paid. She is determined to continue holding the shares – even though their value is falling – in the hope she can break even.
- Confirmation bias – Humans tend to seek out and interpret information in a way that confirms what we already believe, limiting our ability to make rational, independent decisions. For example, if you believe the share market is going to rise, you tend to seek out and read information supporting that view and ignore anything to the contrary.
After buying two investment properties over the past five years and seeing their estimated market value rise strongly, Tom believes property is a great investment that always increases in value.
Given this view, he is keen to buy another rental property in a major regional city with a strong industrial base. However, unemployment is starting to rise and properties are taking longer to sell. Several local property experts are warning prices could decline sharply if a planned industrial project is mothballed.
Despite this, Tom ignores the expert analysis and regularly seeks out alternative opinions ‘confirming’ his pre-existing bias toward investing in rental property and his desire to be ‘right’ about the decision to buy another rental property.
Tips for becoming a rational investor
- Boost your skills and knowledge about investing – Being a good investor means over time you need to build your skills and knowledge.
- Train yourself to think logically – To be a good investor, you need to train yourself to think clearly and objectively at all times to ensure your decisions are based on logic, not emotion.
- Ask yourself if biases are affecting your decision-making – Everyone’s decisions are distorted by pre-existing ideas and views, but the key is to keep reviewing your decisions and trying to improve your ability to think carefully and act prudently.
- Establish clear rules and stick to them – Even great investors are prone to emotional biases. To counter this, they establish a set of strict investment rules designed to reduce the impact of their normal human emotions and keep them on track to achieving their goals.