Make better investment choices by understanding and reducing bias.
Mark Berry - Oct 21, 2022
|Investors are often subject to behavioural biases that can lead to flawed decisions and choices. Being aware of these biases – and understanding how they arise from your background and life experiences – can help you make better investing decisions and achieve your financial goals. |
When we make important decisions about the future, we start with the information and data available to us now and rely on our experiences, education and intuition to come up with the best possible answers. When we don’t have the right information up front, or place too much weight on the wrong factors, decisions may not work out as well as we expect. In Canada, public companies from a range of industries in the high tech, automotive, energy and consumer goods sectors have corporate offices or production facilities in smaller cities and towns. In such areas, the company is often the main employer and a major contributor to the region’s economic wellbeing. Employees and their neighbours often purchase shares in the company for reasons that include their familiarity with the company, the good things that it does for the community and sometimes just because many local people talk about the company. The high level of share ownership is evidence of confirmation bias and, perhaps, home bias. These biases can increase risk, because the decision to invest is based more on local information than on the prospects for the company as a whole. Our biases are shaped and reinforced by our experiences. People that have similar characteristics, such as age range, gender or economic background, tend to demonstrate similar biases.
Market movements and biasIt would be nice if our investments grew at a steady, predictable rate over the long term. Unfortunately, markets go up, go down and sometimes stay relatively unchanged. How savers and investors react to these changes depends considerably on the investment approach they choose. A recent quantitative analysis examined why many investors do not achieve the investment returns they expect, and noted that investment results depend more on investor behaviour than on the way their funds perform. Benjamin Graham, an investor and professor of finance who influenced the investment strategies of Sir John Templeton, Charlie Munger and Warren Buffet, said that the investor’s chief problem – and even his worst enemy – is likely to be himself.
How each of us works through our investment decisions and the emotional ups-and-downs that result from changing market values depends largely on our behavioural biases. When markets are going up we have a tendency to buy in, and when they are in decline, fear can lead us to premature selling.
Adopting a portfolio approach to investing is one way to address these biases. A portfolio approach spreads investments out over a number of areas, so that you don’t have all of your eggs in one basket. Risk is reduced through a more diversified portfolio, and owning a greater variety of securities helps to reduce attention bias. Home bias can also be reduced by specifically including regional representation beyond locally known companies. Disposition bias is addressed by looking at how the portfolio functions as a whole so that selling a single poor-performing security is less of a concern.