Six ways to invest better

Why it’s important to manage your behaviour when investing

25 October 2018

2 minute read

These are common traps to try and avoid when thinking about investing. It’s important to recognise them, and how they interact together.

1) Getting hyped by small passing trends

Sometimes a story creates its own momentum. The challenge is to stay focused on what really matters, rather than getting caught up in the latest fad.

Whether it’s something you read on the web or something your friend recommends, you hear little nuggets all the time and you become emotionally engaged. Shares enjoying strong rises tend to gather this kind of attention, helping to create bubbles.

2) Overconfidence bias

Once investors are emotionally engaged, overconfidence becomes a danger. This means they will limit their research to things that back up their predisposed position, and therefore end up underestimating the risks.

Overconfidence is considered a main factor behind bubbles: it helps people believe house prices or stocks will inevitably rise, no matter what others say.

3) Loss aversion

People are naturally loss averse. They don’t feel gains compensate for the chance of an equally-sized loss. But in finance we can’t avoid losses.

So beware of investment platforms that display gains and losses based, for example, on daily price movements. All they give is a sense of risk and no sense of return. Very few people invest for a daily return; they’re investing for their financial futures over many years.

4) Recency bias

The latest events tend to dominate our minds. So, when markets fall, our risk perception rises, but as time passes, the pain will lessen.

Take two people, both with the same return, but where one has experienced a strong gain followed by a loss, and the other a loss followed by a gain. I’m going to have two very different conversations – even though traditional mathematical finance would say that they got exactly the same return, so they should be equally happy.

5) Action bias

In times of stress, the human psyche prefers action to inaction. This means investors tend to do the one thing that exercises absolute control when experiencing stress from falls in value – sell.

But often the best advice is to follow the principles of good portfolio management and rebalance a portfolio, rather than selling everything.

6) The disposition effect

This is a behaviour shown to cost a lot of money. Investors are much happier to sell winning positions over losing ones. It’s a great ego boost. It gives them the sense that their investment did what it was supposed to do, because they made a profit.

You end up holding the losers too long and selling the winners too early. When you look at what happens over a 12-month period, you’ll often see people would have done better by selling the losers and keeping the winners. The value of investments can fall as well as rise. You may not get back what you originally invested.

To find out how we can help with your investments, contact your Wealth Manager.

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