Investor behaviour: 5 tricks our minds play on us

The quirks and eccentricities of human beings lead us to make simple mistakes when investing. It costs us returns. Here’s how to avoid five investor behaviour errors to invest better.

Investors and traders are just like the rest of us: odd creatures with hand-arm combos and feet-leg additions. All of us are emotional and irrational when we feel like it. Because of this, when investing and trading in high octane markets: fears, anxieties, and past experiences all mash together to create a potent set of irrational instincts. To help you avoid costly errors, here we go through five irrational investor behaviours that need taming.

Investor behaviour 1 – Price anchors warp our investment decisions

We tend to use the past to anchor our expectations of what will happen in the future. A good example is aisle supermarket offers: ‘oooh 50% off’! Even though you KNOW that it’s never sold at £4.88. You are anchoring, using the original price as a flimsy benchmark.

In investing, this has two sets of behaviours attached. The first is seeing an investment that hasn’t been performing and thinking ‘what a basement bargain!’ and piling into it, without considering carefully why it has dropped or whether it will recover. The second is seeing an investment that has performed very strongly and thinking ‘erm, surely this can’t continue?!’, without considering whether there’s a plausible reason why not.

What can I do?

Consider more than just an investment’s past performance. When evaluating funds, think of the long-term drivers of success, the fund manager’s recent reports, how convincing their strategy is, cost, see of the fund, tenure, etc (read Faith Archer’s article on How to choose a fund if you want to know more), in order to create an objective view at a moment time, that isn’t biased by price anchors.

2 – The losers tempt us to keep them

We hate losing more than we like winning. It creates something called the disposition effect, whereby we treat paper loses and wins differently. What we tend to do is sell our winners too quickly, crystallising paper gains, but hold on to our losers for much longer to avoid crystallising paper loses. Clipped wins and continued loses!? This single bit of investor behaviour probably causes your portfolio the most damage over its lifetime.

What can I do?

Stick to managers that have performed well rather than assume they will tank following strong runs. Good strategies should have a robust investment process to select winners for portfolios, so learn to trust this if it’s working for you. On the flip-side, if the portfolio isn’t performing very well and you start to mistrust the manager’s ability to deliver, much like any bad relationship: move on. Think of the opportunity cost of not being invested in a good fund, and the gains you’re missing out on.

3 – Overconfidence drives us down risky side-streets

You’re riding a winning streak, nothing can bash your self-proclaimed sense of brilliance: ‘next, I’m putting my entire portfolio in Swedish sauna companies because I’m brilliant and everything I touch turns to gold. Actually, I could invest in gold…’

Positive returns make us feel clever. But try not to kid yourself. Most of the time it’s broader market moves, with some additional bang from your fund manager (hopefully, if you’re using one). This investor behaviour manifests in us overestimating our own abilities and taking on more risk in our portfolios than is rational to do so. It could unbalance them and lead you to start taking punts, perhaps in more risky single stock positions which involve competition with professional investors. If (let’s face it ‘when’) you start to lose, you then combine your emotions with our previous fear of loss aversion, and punt bigger and bigger to make up the loses. What a treacherous road that may become.

What can I do?

Be humble. Stick to a well diversified portfolio of investments, with a mix of assets that works for your goals, and let it do the heavy-lifting. If you want to learn more about how to structure your portfolio, read ‘Core & Satellite’ investing in our latest mag.

4 – Personal beliefs stop investing rooted in fact

Confirmation bias is the tendency to seek out facts that support our pre-determined conclusions. If we hear John, the neighbour, is secretly having an illicit affair with Miranda from across the road, then we would likely loudly proclaim ‘I knew it!’ and proceed to twitch the curtains for the next four months before remembering you heard a while back that John was in a coma.

In investing, we might overly consider the merits of an investment because a friend said so, we might be attracted to particular funds that our parents have waxed lyrical about or that are well known in the press, or we might focus on singular sources like blogs (ours is fine of course) that don’t provide a balanced view.

What can I do?

Investing requires objectivity in every sense to make sensible decisions. Get your information from a wide variety of sources and make rational, evidence based decisions. This includes different websites, newspapers, trade rags, investment platforms, data providers, asset managers, blogs, and confidents.

5 – FOMO can herd us into mistakes

Often manifested in ‘momentum’ trends where stocks charge ever higher, herd behaviour is the tendency to buy something because other people are buying it. Of course, herding into certain investments can be for rational reasons (Tesla has risen in part because it is a good company playing a decent future theme of electric vehicles), or it could just be a totally bonkers group of investors getting FOMO and piling into a fad, which can lead to stock market bubbles as seen during the dotcom mania of 2001.

By the time you see a hot trend in the papers it may be too late, but at the very least, it’s probably in risky territory. Bubbles have to deflate because prices have become too detached from the rational valuation a sound financial assessment would confer. When they go pop, it’s a recipe for big loses.

What can I do?

Sorry, as fun as juicy trends like bitcoin mania sound, we don’t think its what long-term, sensible investing is all about. Avoid hype, especially around single stock investments. There’s the potential for burnt fingers and this whole investing malarky to become a sad sack.

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Marcus De Silva
Date published:
01 / 04 / 2021
Reading Time:
4 minutes