Behavioural finance biases are typically innocent but unwise ways that humans sabotage their own investment decisions.
Last week, I explained the most common examples of these biases and how they impact your financial plans. As a follow up this week, here are 10 steps you can take to help avoid them and invest more wisely.
Step 1 - Do your homework: Most people notice investment biases much more in others than they do in themselves. Failing to recognize your own biases is itself a bias. Education is an essential tool in recognizing and overcoming your own blind spot bias (for example, realizing that your excessive trading is a sign of overconfidence). You’re more likely to adopt some of the tips listed here to correct it. Acquiring as much relevant information as you can before making decisions is a powerful way to avoid many investment biases. The more time we take to analyze, the less likely we are to revert to biased shortcuts.
Step 2 – Don’t attach too much significance to short-term results: Chasing performance is a type of recency bias. Following the herd rarely pays off, because the players with far greater resources than you have probably identified and exploited the pattern long before you noticed it. Many astute investment professionals suggest that being a contrarian is a wise choice. Warren Buffett said, “Be fearful when others are greedy, and be greedy when others are fearful.” Remember that your portfolio has been carefully crafted with your advisor to achieve specific goals and objectives over a period of time, with an acceptable level of risk, taking into account your personal goals. It makes no sense to ditch it because of short-term fluctuations. And don’t check your portfolio too often: you’ll see more short-term losses and be more likely to make poor decisions.
Step 3 – Seek out alternative scenarios: It can be helpful to be your own devil’s advocate and argue the other side’s case. Being able to appreciate other points of view will clarify your own thinking and help you avoid investment biases. One way to do this is to plot out your decision-making process and identify each step where you had to make a choice. This will help you to consider alternative scenarios and mitigate confirmation bias.
Step 4 – Don’t trust any conclusion drawn from selective data: Seek out as much relevant information as you can but be watchful for the possible influence of the clustering illusion and availability bias mentioned earlier. Whenever you’re considering recommendations from market analysts, friends, journalists or even financial professionals, examine the depth of research behind them.
Step 5 – Keep an investment log: Track your personal hits and misses, along with the ideas you didn’t act on. By continually revisiting your past investment decisions, you can better understand what drives your investing behaviour and avoid behavioural finance biases. By keeping track of your mistakes, you’ll discover if they were due to bad luck or an error in your process that can be corrected.
Step 6 – Don’t react to “noise”: Anything you see in the media is just one data point, so don’t consider acting until you’ve carefully considered others. Remember that many television segments and commentaries are designed to excite or incite, not to educate. If you do consider reacting, talk to your advisor first: together you’re more likely to avoid investor bias and thereby make better decisions.
Step 7 – Trade Less: Every trade has a winner and a loser. Both parties think they are going to win, so one has to be wrong, which is a clear sign of overconfidence in one of them. After fees, commissions and spread, the net gain may be negative, so rational investors don’t trade too often.
Step 8 – Use trading rules: One way to take emotion out of the equation is to use trading rules, based on criteria such as profitability or financial stability (for example, selling an asset if profit margins dip below a certain threshold). This way, you can fall back on rules that are based on solid data, rather than reacting to emotional considerations.
Step 9 – Don’t brag about great picks: Broadcasting your winning investment choices only enhances the emotional investment that results in commitment bias, which prevents you from re-evaluating those choices later. Instead, recommend the services of the investment advisor who helped you thoughtfully and rationally achieve those results.
Step 10 – Use your advisor: A financial planner is your impartial second set of eyes and can counter all the biases listed above. An advisor can help you set realistic return expectations and take advantage of resources to encourage knowledgeable and wise decision making.
Partnering with your advisor can also prevent the active trading that results in poor performance.
The act of discussing and planning for your retirement can help mitigate the overconfidence and optimism biases that can prevent wise investment decisions and also be an effective way for you to focus on the need to save and invest now.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.