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Cognitive biases that are causing investors to make the same mistakes

Cognitive biases that are causing investors to make the same mistakes
31-08-22 / Sisanda Ndlovu

Cognitive biases that are causing investors to make the same mistakes

Johannesburg - In times of volatility, investors tend to make irrational decisions. A recent example is the Covid crash of March 2020, when many investors – fearing a much deeper correction – sold into a falling market, only to miss out on one of the fastest rebounds in history. Markets are not rational and neither do market participants act in a rational manner when their biases come into play.

According to PSG Wealth’s chief investment officer, Adriaan Pask, there are key takeaways from behavioural economics to consider in times of volatility.

“Trading in and out of the market during times of volatility is an expensive mistake that investors make. A well-known study, published 29 years ago, by the research firm Dalbar, showed that US equity investors generate approximately 7% from the S&P per annum, while the return from the S&P itself is closer to 11%. So that 4% erosion is purely through poor investor behaviour.

4% is not insignificant, and when you consider the compounding effect of this lost return it really becomes material. For example, if you had invested $100 000 in the S&P when this study was published three decades ago, the S&P would've returned $2.1 million, while the average equity investor would have ended up with a value of $790 000. This means essentially that only 38% of the value that's generated through equity markets is harvested, and the balance is eroded through improper investor behaviour,” Pask explains. 

History and behavioural economics have shown that investors repeatedly make these mistakes – usually during very volatile markets. This is ultimately underpinned by natural investor biases.

Confirmation bias

“The first bias investors should guard against is confirmation bias, which is essentially looking only at research or a narrative that supports your own view of things. The reality is however that research is ongoing and evolving, and you need to adjust your views as new facts come to light. If you have confirmation bias in your process, you essentially guarantee that you're not adapting your analysis and interpretation of your surrounding environment according to the latest relevant facts. This will lead to costly mistakes,” Pask continues.

Recency bias

Recency bias is, according to Pask, another bias which impacts investment decision-making.

Recency bias essentially states that investors give more weight to recent developments than to more dated ones. So, as time passes, it's more likely that some of the older facts will fade into distant memory.  The studies also show that investors place more emphasis on short-term performance numbers than on longer-term ones. This is analogue to the adage that we find in the sports environment, where they say ‘you are only as good as your last innings’ and everything else is forgotten.”

Pask points out that avoiding these biases start with the acknowledgement that they are predictable.

“All investors are, at the end of the day, just human. When we are under pressure, we do certain things and think in certain ways, and we need to recognise the potential impact of these emotions and human instincts on our behaviour as investors”.

The best way to try and get around that is to get yourself in a place where you understand what your biases are, and then you essentially need to prepare yourself and say, ‘if I'm an equity investor that's going to invest for five to 10 years, at least one, probably two recessions will occur over that period, which more often than not translate into a market pullback’. It is about mentally preparing yourself for that reality and sticking to your investment horizon, plans and goals.

Obviously, it's really important to remain objective – and this is where good objective advice to navigate that situation is important,” Pask concludes. Speaking to a financial advisor can help you identify where your investor behaviour is potentially doing more harm than good, and ultimately help you weather volatile times like the one investors currently face.

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