Interactive Investor

Seven biases that could be hitting your investment returns

28th September 2022 10:00

Faith Glasgow from interactive investor

Faith Glasgow examines seven investment biases that could be hampering your investment returns and explains how to become a better investor.

You may not think the question of investment bias is relevant to you, but all investors have preferences and behavioural leanings that shape their investment decisions, sometimes quite profoundly.

It’s a classic situation in which ‘knowing yourself’ - being aware of your own biases – can help you to make sound choices and avoid mistakes that could mean you underperform the market. Here, in no particular order, are six often interrelated ways in which irrational behaviour and biases can catch us out as investors.

1) Confirmation bias

In cognitive psychology, confirmation bias is the tendency to look for information that supports your perceptions and opinions, and to ignore other information that contradicts them.

As investors, we may easily fall prey to confirmation bias by disregarding potentially useful facts that clash with our preconceptions - after all, it makes processing information and decision-making much less stressful, and makes it easier for us to feel good about our decisions.

For instance, during the growing technology bubble of 2020-21, many investors kept the bulk of their portfolios in the high-growth-focused funds and stocks that had done so well and were becoming increasingly highly priced, ignoring the valuation warning signs.

To counter such bias and avoid the risk of jumping on a bandwagon that subsequently crashes, investors should actively seek out contrarian viewpoints and try to take account of them when making decisions.

2) Overconfidence

If you’ve had a run of strong performance with your portfolio, you run the risk of being lulled into a sense of false security. But did you do well because you made well-informed, rational decisions, or because you were lucky with your choice or with wider market trends?

The danger is that you focus too much on particular parts of the market where you’ve had success and dive into high-risk investments without weighing up the risk involved.

Instead of rushing in, it’s important to take some time to analyse and research your investing decisions. Stepping back and thinking through your investing choices can make all the difference in the long run. It can help you block out the noise and make unemotional and rational long-term investing decisions.

3) Lack of diversification

As mentioned above, one potential consequence of being too confident in your own investment capabilities is that you may over-invest in particular parts of the market, funds or shares where you’re apparently doing well. But everyone can make mistakes. Even the most experienced investors sometimes make the wrong call, and those with a heavily weighted portfolio will be harder hit than if they were properly balanced.

By ensuring your holdings are well diversified - across different regions, sectors, company sizes and investment styles, and also across a range of asset classes with different qualities – you can build a more robust portfolio that will deliver more consistent returns and tend to outperform over time.

That’s because not everything will be equally affected by external events, and similarly internal troubles for any one company or sector will only impact on a relatively contained part of the whole.

4) Sunk-cost fallacy

There’s a tendency for people to continue with an activity that is disappointing them, because they have already invested time and/or money in it. So you might doggedly finish a book you’re not enjoying, simply because you’ve read half of it.

Investors often fall into the sunk-cost trap by holding on to underperforming investments beyond a reasonable length of time, or even adding to them – whether because they don’t like to admit they made a bad call, or because they are hoping somehow to recoup their losses.

The danger is not just that the investment continues to disappoint, but that they miss out on much better opportunities through their determination to stick with it.

In contrast, rational behaviour would dictate that they should look to the future, consider the opportunity cost of continuing to hold that investment, cut their losses and focus on better alternatives for that money.

One way to avoid this bias is to set an investment goal for your portfolio – perhaps an annualised return of 8% over two years. If the portfolio as a whole falls short, you can assess where the weaknesses are and take action.

You can also focus your attention on the opportunity costs of each holding very effectively by limiting the number of holdings in your portfolio, so that each constituent becomes an active choice weighed against the attractions of possible alternatives.

5) Short-term focus

We are all bombarded with huge quantities of economic, financial and market information every day, and it can be a real challenge for investors to sift through and focus on the relevant stuff rather than the ‘noise’.

The most dangerous distractions can come from short-term market movements that lead investors to panic and sell perfectly good quality investments, or conversely to buy mediocre shares simply because the price is rising.

Anyone with a medium or long-term focus for their portfolio should really ignore the daily ups and downs of the market or specific share prices. If you’re buying a share to hold, concentrate instead on its prospects for the medium term and its current price relative to those prospects.

6) Past performance bias

We have all seen the warning that past performance is no guarantee of future returns so often that we probably no longer even register it. But the message is an important one.

It warns against the inclination of many investors to rely too heavily on past references, such as the price of a share relative to its trading history. That may lead them to buy stocks that have had a good run, but it tells them nothing about whether a stock is cheap or expensive relative to its intrinsic valuation, or what shape the company is in.

A similar risk exists for fund investors. It’s all too easy to choose funds based on their short-term performance within their sector, without looking at the factors driving returns, or at the nature of the underlying portfolio, or the manager’s investment strategy and process.

Remember, fund managers can top the tables through luck rather than skill or good judgement – and their run of luck may end as abruptly as it began. Past performance may be one consideration, but rational investors will understand more about the wider context and quality of the investment in order to make an informed judgement.

7) Oversimplification bias

Some investments are inherently much more complex and opaque than others. Think about the numerous unknowns surrounding cryptocurrency, for instance, in comparison with a blue-chip such as Unilever (LSE:ULVR) where profit and growth forecasts are likely to be pretty reliable.

We tend to want clear, simple explanations even for these complicated products, and we’re prone to make poor investment decisions when we oversimplify the way they work and the range of potential outcomes in order to allow ourselves to get on board.

One way to avoid this is to invest only within your ‘circle of competence’, seeking out stocks or other investments where you have a good grasp both of what they do and of how the fundamentals stack up.

If you want exposure to, for example, biotech or cloud computing but don’t have specialist knowledge, consider taking a small position (diversification rules the roost!) in a focused fund or investment trust where an expert fund manager makes the investment decisions on your behalf.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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