Have you ever made an investment decision you later came to regret? Perhaps you sold some stocks during a bout of market volatility, only to see their stock price rebound shortly after the volatility passed.
Don’t beat yourself up. No one – not even Warren Buffet – is exempt from the emotional and cognitive biases that push us to make less-than-perfect investment decisions. A deeper understanding of our thought processes however, can guide us towards better decision making.
Take our quiz below to find out which common investing bias may be keeping you from your financial goals.
1. You buy some stock in company A and find that it’s down 30% from what you paid for it due to a deterioration in the company’s fundamentals. What do you do?
- Re-evaluate the stock to decide if it should still have a place in your portfolio
- Hold the stock until the share price rises to at least what you paid for it
Answer: A
Assessing your investment in company A is the right move. Ask yourself if the reason you bought the stock is still valid. There could be more suitable stocks for your portfolio – provided you’re willing to let go of what no longer works.
Some investors choose to hold onto a stock until it reaches a particular value, such as the price they paid for it. This is a behavioral bias known as anchoring. Anchoring the investment to its cost alters the way you view the investment and subsequently how you react. Other investors may also be reluctant to let the investment go – an emotional bias known as the endowment effect, where we often place a higher value on things we already own.
2. You need to sell some of your stocks to raise money for a business venture. You own 500 shares each in company X and Y, having bought each share at $100 a few years ago. Since then, the share price of company X has fallen to $80 while company Y has risen to $120. You’ve evaluated both companies and the reasons why you originally bought the stocks are still valid. Which of the stocks do you sell?
- Company X
- Company Y
Answer: A
Daniel Kahneman, winner of the 2002 Nobel Prize in Economics, sums it up best when he wrote, “The concept of loss aversion is certainly the most significant contribution of psychology to behavioral economics.”
Selling shares of company Y (the winning investment) is an example of loss aversion – investors are so fearful of losses that they tend to avoid losses much more than making gains. Studies have shown that the pain we feel from losing money is nearly twice as much as the joy we feel from gaining the same amount of money.
As such, many investors will choose to hold onto a losing investment (shares of company X in this case) to avoid realising the loss that comes with closing out the trade, even if they may end up losing more money than necessary. This is because a loss on paper may not seem as painful as a loss in reality.
Conversely, many investors may then sell the winning investment to lock in the small investment gain, even if the stock should be held longer for a much larger profit.
3. Suppose the stock market was underperforming. After it recovers, you review your investments. What is your best course of action?
- Protect your portfolio against future downturns by reducing your exposure to equities
- Stick to your asset allocation strategy because your investment goals remain unchanged
Answer: B
When markets go up, investors are more likely to think that the markets will continue to outperform; a bear market is the furthest from their minds. Conversely, after markets go down, investors start expecting another market downturn to happen soon. This phenomenon is called the recency bias. We look at the most recent evidence, extrapolate it, and expect that the trend will continue into the future.
Many investors forget that markets are cyclical. After a downturn, no matter how severe, markets tend to stabilise and eventually resume their upward trajectory. Investors who sell their stocks after a downturn may miss out on the chance to recoup their losses and make a profit when the market inevitably recovers.
4. You see a tremendous amount of buzz around company ABC in the media and on financial blogs – the company has just released several new products. You have $10,000 to invest. What is your next course of action?
- Go all in on stocks of company ABC
- Diversify your investment by investing in an exchange-traded fund (ETF)
Answer: B
If you decided to purchase stocks of company ABC after you saw the CEO being interviewed on TV, you may have succumbed to availability bias.
Availability bias is a cognitive bias where people make decisions based on information that is more recent or memorable. In other words, if something can be recalled more easily, it must be more important than something which doesn’t come to mind as easily.
What’s more, investing solely in stocks of ABC exposes you to unsystematic risk, or the risk related to one specific stock. As the fortunes of Swiber, Hyflux and Lehman Brothers illustrate, there are specific factors that can derail the performance and share price of a particular company.
You can protect yourself from unsystematic risk through diversification. One easy way would be to invest in ETFs so you can invest in multiple companies across different sectors and markets at once.
5. After doing your research and due diligence, you excitedly buy two promising stocks. But a year later, one stock has surged while the other has slumped. How would you describe your performance?
- To be honest, just average
- Brilliant! I picked the right stock
Answer: A
In reality, your stock picking track record is quite average considering only one stock was spot on. But that’s okay, even professional fund managers have a hard time consistently picking the right stocks. Many investors only remember they knew the rising stock was going to perform spectacularly all along while ignoring the fact they were equally sure about the other stock. People tend to forget the odds they previously assigned to an outcome once that outcome becomes known – an effect called hindsight bias.
Becoming a more rational investor
Knowing how we should invest and what we actually do is only half the battle. Syfe overcomes human biases in financial decision making through the use of algorithms and automation to construct portfolios and manage investments. Side-step impulsive decision making. Learn more about Syfe’s investment management services today.
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