In February 2023, Britain’s FTSE 100 reached a record high, even though the UK was expected to fall into a recession at the time. According to the Guardian, the index’s stellar performance was driven by several factors, including investor optimism about the World economy and the belief that the UK economy could do better than expected.
This reminds us that the markets are often driven by investor sentiment, and not the economy. While this could be good news, it’s important to remember that investor sentiment is formed by individual beliefs, which can be influenced by ‘behavioural biases’.
These are deep-rooted beliefs and processes that humans use when making complex decisions, which could include your investments. What you may not realise though, is that if you let these biases control your decision-making process, they could result in you making choices that you later regret.
So, with this in mind, read on to discover five powerful biases that you need to avoid, and why falling foul of them could cost you dearly.
1. Loss aversion
This is one of the most powerful biases and is driven by the human desire to avoid losses. Various studies have suggested that humans feel the pain of loss more deeply than the pleasure of a gain, which is why many investors consider loss avoidance to be as important as making gains.
Loss aversion is often behind the decision to sell investments when the stock market suffers a downturn. More often than not though, doing this in a bid to avoid further losses increases the possibility of actually making one.
Just as importantly, it also deprives the investment of any potential to recover when the stock market bounces back, which historically, it’s tended to do. That said, please remember that past performance is no guarantee of future performance.
2. Confirmation bias
Confirmation bias is when a decision is made based on a preconceived idea and is one of the most common emotional biases when it comes to investing. This could result in you, for example, researching an investment when you’ve already decided whether it’s right for you or not.
This increases the chances of you making a decision that’s based on a pre-established assumption instead of factual evidence. As a result, you could go ahead with your original investment idea despite all the evidence showing that it’s not the best option.
3. Anchoring bias
This refers to an over reliance on a specific piece of information, which could result in you making a decision using data or information that was once correct but isn’t any longer.
An example of this might be you deciding to place your money into an investment because someone once told you to do so, when in fact, it’s no longer right for you. Conversely, you may fail to sell your investment when you should.
4. Endowment effect
This bias results in investors giving certain funds or shares that they own a higher value than the ones they don’t. As a result of this belief that the funds or shares are more valuable than they really are, the investor is more likely to hold on to an investment when the better strategy could be to sell it.
If you fall foul of the endowment effect, you may hold on to a fund or shares instead of letting go of them, only to see them plummet in value later on.
5. Bandwagon effect
This is a particularly dangerous bias during a stock market downturn. In a nutshell, its where individual investors make a decision that’s based on a commonly held belief.
As we have already seen, loss aversion can drive many investors to sell up when the markets become volatile. If you see other investors selling, you could fall foul of the bandwagon effect and decide that this is the best policy and do the same, when in fact, it might not be.
Please remember that if you’re considering selling your investments during a downturn, you should always take extreme care and speak to a financial adviser before going ahead.
A financial adviser can help you to avoid these damaging biases.
Working with a financial adviser could be an extremely shrewd strategy, as they could provide you with an independent opinion about the actions you’re considering. This means they could confirm whether it’s the best option available to you, as well as any risks that could be involved.
They could also provide alternative actions that you may want to consider. This could help you to sidestep a costly mistake and expose your money to greater growth potential in the future, which could help you to achieve your financial goals more quickly.
The latter is backed up by research carried out by the International Longevity Centre UK, which makes for interesting reading. It found that people who worked with a financial adviser were on average £40,000 better off than those who don’t.
If you would like to discuss your investments, or wider wealth, we’d be happy to help. Please call us on 01527 577775 or speak to one of our advisers.