Controlling our biases is vital for investing successfully

Eleanor Williams, Partnerships Director

“I have lived through terrible things in my life,” wrote Mark Twain, “some of which actually happened.” 

The writer’s quip summed up perhaps one of the most fundamental day-to-day challenges of the human condition; we imagine many problems, and only some of them come true. 

This very human difficulty plays out not just in our daily lives but in the systems that we create, including the stockmarket. It is for this reason that economist Paul Samuelson once offered a financial riposte to Twain’s psychological angst: “The stockmarket,” he wrote, “has predicted nine out of the last five recessions.” 

The great difficulty presented by this problem is that it leads investors to respond to events in the world by selling their shares, anticipating that the very particular circumstances and issues they are able to identify will be the ones that bring stockmarket’s down. Of course, every so often these investors are right, but because markets do usually go up over the long term (and have done so for 200 years), they are usually wrong. 

Most stockmarket corrections do not signal recessions, and markets bounce back. 

This can lead to profound long-term problems for investors because when we panic and sell, even if markets do subsequently fall, we are rarely able to time our re-entry in the midst of whatever crisis is befalling the world. As a result, the consensus of academics has been for decades that an investment strategy that tries to time the market is implausible. Some may be successful, but the vast majority will not and therefore it requires a supreme self-confidence to use this technique when, over the long term, those who stay invested and ignore the peaks and troughs have received good outcomes. 

Indeed, research from the United States, which examines the pension outcomes of millions of citizens when charted against whether they tend to be highly anxious people, shows us that the more anxious amongst us receive materially worse financial outcomes. This is in part because of erratic buying and selling behaviour and partly because those who suffer from anxiety find it hard to take any investment risk at all. Ultimately, it is risk that delivers returns.  

This instinct to respond and time markets is just one of several key behavioural instincts that exist within us, emotional desires that can lead us away from cold, hard, rational facts when making judgments about our investments. Investing smartly is about understanding how these biases affect us and disciplining ourselves to respond to them. 

Here are three biases that every investor should watch. 

Confirmation Bias 

Arguably, the most pernicious bias that affects us all is confirmation bias. We tend to look for information that confirms what we already believe. If we are anxious to begin, we will be more sensitised to data that supports our fears. 

Fears feel immediate, and the more evidence we see to support them, the more likely we are to believe we need to act upon them urgently. The risk here is that a short-term burst of negative news about the global economy, for example, can lead us to an immediate reaction because we perceive the problem as urgent; only to discover it then reverses. If you think you are not sensitive to this problem, remember back to a time when you were anxious about something, perhaps a medical concern, and remember how it felt like for a period of time, every news story was suddenly about that condition. Confirmation bias robs us of our ability to make good, sound decisions and can lead us to believe problems are more urgent than they really are.  

 

Recency Bias 

Stockmarket investing is about the long-term; it is about understanding how multi-year patterns can ultimately lead us towards our goals. Yet our brains are programmed to place undue weight on recent events. If stockmarkets have just fallen in value, we tend to think that this means they will fall further. Likewise, if a stock has just risen sharply, we tend to worry that we are missing out. Successful investment involves discounting recent data to put it in the context of the longer term. 

Endowment bias

We are programmed to believe that what we own is valuable to us. This can lead us to treat abstract things like a holding in a fund or a share as if it were a personal possession. This thought process leads us to think “I’ve owned this for years and it’s always done well for me.” In short, we feel attached to it. Shares are not heirlooms. The investments we own are just one option among thousands. The world does not care if we buy or sell them, and we must make judgements based entirely on an appraisal of their prospects. As one famous fund manager, Anthony Bolton, once said, it is best to ‘forget the price you paid for a share.’ This is because the amount of money you have made in an investment or lost in a bad one does not actually tell you anything about whether it is currently a fairly-priced opportunity.  

Ultimately, even the best fund managers and the best financial institutions are vulnerable to the same psychological challenges as every private investor. We seek to control them through a variety of mechanisms, such as making decisions collectively and challenging judgements in committees. Crucially, we also use a range of tried-and-tested market signals to tell us when the time might be right to make adjustments to portfolios, which are based on robust long-run data analysis rather than our instincts and feelings in response to news events. None of us are immune to the psychological challenges of investing, and we can never allow our guard to fall.