Provided by Mercer: 31/1/08
‘Behavioural biases’ can affect your decision-making, even if you’re a savvy investor.
Did you know only 17 per cent of Australians invest all of their investments according to their financial adviser’s recommendations?1 Despite the value that sound financial advice can offer, investors often act according to emotions rather than logic.
You can learn a lot about investing, and yourself, by understanding how ‘behavioural biases’ work.
The term comes from Behavioural Finance, which blends economics with psychology2. This school of thought suggests individuals don’t always act rationally when making investment decisions. Instead, they generally lean toward common responses – or behavioural biases.
Importantly, investors tend to follow behavioural biases even when they are informed, knowledgeable and understanding of a situation. As a result, they may not utilise all information available to them.
There are several typical biases:
- Overconfidence – this is when you overrate your own skill and ability in a range of financial activities. In a share market context, it may be when you believe you’re more able or knowledgeable about making an investment decision than another person.
- Loss aversion – generally, you may accept a small anticipated loss rather than a really big unanticipated loss. Therefore, you have trouble ‘cutting your losses’ when an investment reduces significantly in value and may tend to hold on too long, in the hope of recovering falls in value.
- Confirmation bias – similar to overconfidence, this bias occurs when you see a positive outcome as confirmation that an earlier decision was soundly based. With favourable outcomes, you are less likely to reassess the underlying reason for the result and the probability that gains will be repeated.
- Framing – you may unconsciously vary your response to an investment decision depending on how a particular question is asked or ‘framed’. For example, when asked to select a superannuation investment option, you may choose a growth option if there are more of these on offer than defensive options.
- Anchoring – this is when you focus on a specific value as a basis on which to compare or estimate future possible outcomes. While it’s natural to make decisions from a point of familiarity, the tendency to latch onto something you know may reduce your receptiveness to other important information.
- Status quo bias – related to anchoring, this bias is where you prefer to maintain your current position rather than move to a new position.
- Myopic loss aversion – Myopic loss aversion is when you focus on small recent occurrences in the investment markets without considering the actual implications for achievement of your goals.
An interesting point to consider
Fund managers and financial institutions can also be affected by behavioural biases – not just individuals – although many have responded to reduce the impact. For example, a fund manager’s bias on portfolios is usually kept in check by committees and processes that limit how much of any one stock or sector can be held. Some trustees of Self Managed Super Funds (SMSF) manage behavioural biases by implementing a sound investment strategy.
Either way, biases may increase your exposure to different types of financial risk and could limit your potential for returns.
There are a number of action steps
The first is to be aware of the common biases. Understand each and recognise when you might be affected by them. Becoming self-aware is essential if you are to break old habits.
The second step is to enter the decision-making process with the goal of using the information, your education and understanding of the situation to reach a solution as dispassionately as possible. In other words, this step is about returning rationality to your decision-making and removing emotion.
The third is to reflect on your decision. If you think again before you act, you may be more likely to consider new information or old experiences previously ignored or overlooked.
The fourth step is to make investment decisions in conjunction with a licensed, or appropriately authorised financial adviser. A professional financial adviser can bring perspective to the decision-making process, along with their own financial experiences and research information or material. They’ll also keep your life goals or specific financial objectives in mind – rather than emotions - when making a recommendation.
More information
To speak with a Mercer financial adviser about your investment strategy, call us on
1800 633 403.
1 ING study of June 2007, reported in Money Management, 5 November 2007 moneymanagement Accessed 11 December 2007.
2 Knight, D., ‘A guide to behavioural finance’, Mercer Investment Consulting, MercerFundWatch.com, February 2006, pp 1-5.
This information has been prepared by Mercer (Australia) Pty Ltd ABN 32 005 315 917 for general information only. The information does not take into account your personal objectives, financial situation or needs. Therefore, you should not act on this information if you have not considered the appropriateness of this information to your personal objectives, financial situation and needs. You should consult a licensed or appropriately authorised financial adviser before making any investment decision.
