By PATRICK CAIRNS
When it comes to investing, we are all at risk of making decisions that may not be in our best interests. We are all prone to psychological biases that affect the way we act.
For example, it is well established that humans feel the pain of a loss around twice as strongly as we experience the joy of a similar gain. In other words, almost everyone would rather not lose £100 than win £100.
This impacts the way that we consider investment decisions. In order to avoid experiencing losses, many people invest too conservatively. They favour cash and bonds and therefore miss out on the long-term compounding gains that can be made from the stock market.
Overconfidence and herding
It is now well understood that everyone is affected by these kinds of psychological biases to some degree. There is also growing evidence that certain biases are more common in men, while others are more likely to affect women.
A paper published recently by three Sri Lankan academics led by Meerakkuddy Siraji from the Sri Lanka Institute of Advanced Technological Education, found that:
“Females tend to follow other investors in investment decisions. On the other hand, the effect of overconfidence on investment decision-making was found to be significantly stronger for male than female investors.”
This is further confirmation of what a number of other studies have already suggested — that men tend to overestimate their own abilities when it comes to making investment decisions, while women are prone to a “herd” mentality and investing with the crowd.
To anyone with any life experience, this probably won’t sound particularly revolutionary. These are traits that characterise the behaviour of men and women in many settings.
Men tend towards wanting to take action, and are often at risk of over-estimating their ability to tackle a problem. Women, on the other hand, are more likely to want to talk things through and find a consensus view on what should be done.
Of course, this doesn’t mean that all men will be overconfident, and not all women will be prone to herding. These are broad generalisations and should be understood as such.
However, it’s worthwhile to understand that we might be predisposed to these biases. This insight allows us to scrutinise whether we are in fact making decisions in a certain way, and to do something about it.
Know your limits
For example, frequently changing the funds we are investing in because we believe we are able to identify where outperformance is going to happen next is an obvious sign of overconfidence. Nobody can consistently predict the movement of markets in the short term.
There are three simple ways to address this overconfidence:
- Seek out an alternative opinion. Overconfidence is fed by only considering information that supports the view you already hold. Find an opposing view, and force yourself to think about what would happen in a worst case scenario.
- Acknowledge your mistakes. Even when we have been wrong, overconfidence can lead us to blame someone or something else, like an Elon Must tweet or an unexpected Brexit vote. But it is only by accepting your errors that you will learn not to repeat them.
- Don’t act alone. Overconfidence leads us to believe that we always know best and can handle everything ourselves. Having a financial adviser to guide us and ask the right questions can significantly lower the risk of making mistakes.
Similarly, some of us might reflect on our behaviour and realise that we are only comfortable making investment decisions when we know other people are already doing the same thing. This is a sign of moving with the herd.
There are three simple ways to address this too:
- Avoid the short cut. Going with the crowd can feel like the easier option. If other people are doing something already, we might assume that they have thought about what they are doing, and so that means we don’t need to think too hard ourselves. However, nothing can replace doing your own research, your own analysis, and coming to a decision that is best for your own situation.
- Know your options. The more you know, the less likely you are to let other people’s choices influence your own. Empowering yourself is like a vaccine against herding.
- Get support. Going with the crowd often comes out of a need for confirmation that we are doing the right thing. If others are doing it, then we can feel more at ease. Having a financial adviser who can provide support and acknowledgement can provide the same comfort, but likely with much better outcomes.
One of South Africa’s most respected financial journalists, PATRICK CAIRNS is a trusted commentator on the world of investments and the quirks of behavioural finance. Over more than a decade he has built a reputation for keeping the industry honest, and putting the interests of investors first.
Here are some more articles by Patrick Cairns:
So you think you’re a rational investor?
Clarity in investing is not the same as certainty
Don’t let your investments go the way of the CD
PREVIOUSLY ON TEBI
It’s having friends, not money, that will make you rich
Charles Ellis on the game you shouldn’t play
Active share has been a big disappointment
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