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What drives some stock prices to soar? What brings people to jump into investments that they know little about? And why might they intrinsically favour one type of investment over another?
Behavioural finance biases help us understand just why people tend to make emotional, and not rational, investing decisions. It explains why our financial decisions don't just live in the spreadsheet but also in our emotions and psyche.
Emotions, such as fear, greed, or excitement, are what make us human. Still, they can drive you to make irrational investment decisions that can hurt your investments and financial wellbeing.
Notifications like these might pressure you to invest sooner than you’ve planned.
How can you ensure that your emotions don't end up getting in the way of managing our finances responsibly? It all starts with being aware of your blind spots and keeping your financial plan in check.
Here are 7 behavioural finance biases to look out for:
The home country bias is the tendency for investors to invest the majority of their portfolio in domestic assets.
This tendency occurs because it’s psychologically easier to part with money when investing in familiar brands instead of unfamiliar brands. And often, those brands that are familiar tend to be domestic ones.
But, investing too much in your home country can risk your investments being too concentrated in a single geography. If your home country suffers an economic downturn, it could negatively affect your portfolio. If, however, you diversify your investments across geographies, you’ll always have a buffer in case one market is disproportionately affected due to a market downturn.
Home country bias is a worldwide phenomenon. For example, US equities represent less than 50% of global market capitalisation, and yet the average US investor has 70% of their portfolio in US equities.
“You need to have a sufficient amount of funding and safe-haven currencies in your portfolio. Because these are the ones that give your portfolio insurance when times are tough.” - Freddy Lim, Chief Investment Officer, StashAway
Similar to the home country bias, the home currency bias refers to the tendency for investors to hold their investments in their domestic currency instead of foreign currencies. Because foreign currencies are subject to fluctuations against domestic currencies, many people see these fluctuations as a risk to their financial planning.
But some currencies tend to perform better in times of economic downturns. Historically, the US Dollar, Japanese Yen, and Swiss Franc have outperformed other currencies during the 2008 financial crisis and the COVID-19 market crash. So keeping assets in these currencies, and not only in your home currency, can help you reduce risk in your portfolios.
People tend to feel disproportionately stronger about potential losses than gains. Daniel Kahneman, psychologist, economist, and author, explains why humans are prone to this behaviour in his book, Thinking, Fast and Slow (2012):
“This asymmetry between the power of positive and negative expectations and negative experiences has an evolutionary history. Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”
In other words, we’re evolutionarily wired to react more urgently to negative experiences than to positive ones (or in the case of investing, to potential losses).In investing, loss aversion bias can lead to an investor taking too little risk or even no risk.
Here’s an example: when there’s short-term volatility in the market, loss-averse investors are more likely to sell their investments quickly to minimise their losses. They often only continue investing when the markets and their emotions have recovered, meaning that these investors will often end up buying securities when they’re expensive.
And those who take little to no risk may end up with too much of their wealth in cash. As cash depreciates against inflation, extreme loss aversion makes reaching their long-term financial goals much more difficult than if they were to invest for those goals over the long term.
Have you ever gone somewhere only because you already paid for it, but didn’t feel like going once the time came around to leave? This tendency to commit to something only because you’ve invested in it is known as the sunk cost fallacy.
There are many reasons why you may feel attached to an investment despite it no longer serving you. For example, you might have spent a lot of time and effort researching a company, convincing yourself of that company's worth. Or you may feel closely connected to a company's vision because it's shown promise for a certain disruptive technology that you support.
The sunk cost fallacy may lead investors to commit to an investment for longer than they should and keep more risk in their portfolio than they had initially planned.
Our minds have limited bandwidth, so it's easier to digest very recent information than information you received a long time ago. This bias can distort how we make decisions, as our minds tend to disproportionately emphasise recent events.
For example, if you recently picked one or two funds successfully, you're more likely to think of yourself as a great investor. But, of course, this view is distorted because of how recent your experience is. This bias could lead you to over-attribute your success to your investing skills rather than the financial market's general performance.
The risk with the recency bias is that investors continue to do what's currently working for them. By focusing on short-term returns, they could miss out on other, more important factors. For example, an investor may have made great returns by recently investing in a particular fund. As a result, they continue investing only in that fund, while ignoring its long-term performance.
When it comes to investing, it's increasingly easy to seek confirmation on a particular asset’s performance. Think Bitcoin will reach 100K SGD in value? You'll find plenty of sources confirming your belief, but it takes discipline to seek differing opinions and risk analyses. So, this bias can lead investors to double-down on their own investment narratives without properly assessing risk.
We subconsciously assign more trust and meaning to stories that are easy to understand and seem to make sense rather than those that are complex and require critical thinking.
Because financial markets and financial planning can seem so complex, it's all too easy to heed the advice of a close family member or friend “who made 70% returns” with a financial decision.
Our investment team regularly reminds our clients not to act on anecdotal advice without doing research. Making investment decisions based on headlines instead of research puts an investor in precisely the worst situation because, by the time they get in on belated information, they’re probably amongst the last few people to do so. That means that they’re also likely to buy their investment at an inflated price.
Even better than doing all the investment research yourself is to leverage a professional who’s already done it for you: our team, for example, has more than 50 years of investment experience and has dedicated more than 30,000 hours to research and backtesting.
You can take certain steps to keep your emotions in check when investing. One way is to reduce the number of investment decisions you'd have to make in the first place. This could be as simple as having a financial plan that allows you to invest regularly into a diversified ETF portfolio for the long term, eliminating the need to pick stocks and time the market.
But, keeping your emotions out of investing doesn't mean you can’t, or shouldn’t, invest in a company or cryptocurrency you’ve thoroughly researched and feel passionate about.Your financial plan can have room for you to invest systematically while leaving a portion of your wealth to invest in those companies or brands that you really love.
Want to know more about behavioural finance? Tune into our podcast, In Your Best Interest, to learn more about How Your Emotions Might be Hurting Your Investment Outcomes with Dr. Joanne Yoong, Senior Economist at the University of Southern California, and Freddy Lim, Co-founder and CIO at StashAway.
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