Why do we have investment biases?

As he took the turn, he was edging ever closer to his idyllic cottage. It had been a tough week and he was looking forward to relaxing and unwinding. And then it happened, he ran out of petrol. On a country road, with no petrol stations for a couple of kilometres, he came unstuck, figuratively and literally. The cursing began, followed by a good kicking of the tyres; he wondered how he could have been so stupid. Why didn’t he check the petrol tank before leaving? He’d meant to do it, but he’d forgotten.

He was unaware that the brain’s thinking centre (the pre-frontal cortex) which sits right behind our forehead, has limited capacity, a capacity that we can increase and improve upon, but only with focussed practice. We only get so many good decision-making hours a day (and this will vary by individual).

The man’s week had been tough. Waking up exhausted, he deliberated over which tie to wear, what to pack for his weekend away, whether he’d leave straight from work or come home first, whether to have the muffin or the toast for breakfast, carefully weighing up the pros and cons of each decision. These decisions, though small, were eating into his limited brain capacity, at the same time lowering both his judgement and his tolerance.

Every decision we make, every piece of self-control we exercise (like denying ourselves chocolate to eat a raw carrot instead), no matter how big or small, chips away at that powerhouse in our head.

The brain supports us by giving us shortcuts. We can call them heuristics, stereotyping, assumptions or biases. In essence, if we have a brain, we are biased. We need these biases, assumptions and beliefs to help us navigate the estimated 11 million pieces of stimuli we receive every day (most of it without our conscious awareness). But biases also have their pitfalls. It is estimated there are around 200 cognitive biases, but let’s take a look at three of them:

Overconfidence bias

This includes a self-belief in one’s ability to pick the right stocks and to time entry and exit into the market or certain stocks. Yes, a level of confidence is good and certainly, things won’t go our way all the time, but overconfidence bias can leave us blinded to contrary indicators or red flags. In this way, it can be akin to confirmation bias (where we only consider information that supports our beliefs or assumptions and discount the rest).

Loss aversion

Our brain is more geared towards avoiding loss than towards chasing gains. A loss aversion bias could result in us not acting at all, standing on the sidelines with our cash ‘safely’ in the bank or channelling our hard earned savings into a risk-averse portfolio when, to fund our wants and dreams, we need a growth geared portfolio (which appropriately assesses and balances risk).

Anchoring bias

If I asked you whether the man’s car would cost more or less than $500 to refill with a new green energy petrol that’s brand new to the market, your guess will likely be influenced by the $500 as it’s the first piece of information you’ve been given. If I tell you that it’s only $200, it will likely seem cheap. But, if I’d anchored you at $100, $200 would seem like a bad deal and you may back away.

Any of these biases (plus the other estimated 197 of them) can cost you money.

Investing can be very personal and therefore very difficult. When things are difficult, the emotional part of our brain (the limbic system) usually comes into play. Our emotional and executive brains co-exist, but when one is active, the other is not. It’s like the rider and the elephant. The rider (the executive brain) thinks it’s in charge. But if that elephant (the emotional brain) wants to go running through the jungle, the rider is next to powerless to stop it.

Here’s where your financial advisor comes in. Backed by a team, and by each other, they are skilled in understanding your circumstances, your goals, your risk appetite, the markets and the best strategy for you. Our robust research and processes are designed, as much as possible, to guard against cognitive bias to improve decision-making and present you with objective options and advice. And, they are trained elephant tamers. Their role is to clear the path, manage the emotion and allow the rider to regain control.

Please note this article provides general advice only and has not taken your personal, business or financial circumstances into consideration. If you would like more tailored advice, please contact us today.