People are emotional beings, often guided by feelings in unexpected ways. They may lose control to anger, covet things with envy, or lust after short-term satisfaction and joy. Emotions can skew judgement and promote irrational decisions.
There are all kinds of emotionally fuelled psychological biases that can affect decision-making and might potentially push your clients towards making harmful investing choices.
For every devilish bias whispering in your clients’ ears, the “angels” at Grey Parrot are here to sit on their opposite shoulder and give them the advice needed to help them continue uninterrupted towards their long-term goals.
Discover seven psychological biases your clients are likely to want to avoid to protect their investments.
1. They shouldn’t give into anger, frustration, and fear — the bias known as “loss aversion”
The theory of “loss aversion” posits that the pain associated with loss is felt twice as strongly as any joy produced by gains.
This can prompt your clients to give into frustration, anger, and fear during periods of economic downturn and look to sell their investments to mitigate potential losses.
However, this can be a harmful move in the long term, as it effectively converts what might have been a paper loss into an actual one, and removes any possibility of their investment bouncing back in the future.
Remember: if your clients are calm and patient, their investments will likely bounce back from short-term dips, and continue to grow over the long term.
2. They shouldn’t be envious of others’ gains and chase the same returns by succumbing to “herd behaviour”
“Herd behaviour” occurs when investors decide to follow the opinions or choices of others, instead of opting to make their own informed decisions.
This can be especially prevalent when your clients’ peers are all moving their funds into a certain stock, and your clients worry about missing out on any potential returns the group might make, and so decide to follow suit.
It is vital that your clients remember to think for themselves and not simply follow the herd.
3. They shouldn’t let short-term gains fuel their pride and ego and let the “overconfidence effect” skew their judgement
The “overconfidence effect” is a psychological bias that can skew your clients’ perception by imbuing them with a belief in their better judgement that is greater than its actual objective accuracy.
If your clients have a string of short-term investments that produce sizeable returns, they may fall victim to this bias. According to ResearchGate, overconfidence can push investors to overestimate their abilities or knowledge, which can lead to detrimental outcomes.
If your clients succumb to overconfidence, they may mistakenly believe they can predict the market, which very rarely happens and can be incredibly harmful to their long-term investing outlook.
4. They should remain wary of the temptation of greed and be aware of the “restraint bias”
“Restraint bias” is the tendency for individuals to overestimate their ability to show restraint in the face of temptation. Greed can be very appealing, as it involves more of a good thing, and in investing terms can push people to chase more than they need, which can increase their exposure to risk.
If a string of successes convinces your clients they are onto a “guaranteed winner”, they may funnel more and more funds into their investment, potentially taking on more risk than they are able to handle.
It is important your clients put risk controls in place and seek level-headed third-party advice before rushing into any risky decisions.
5. They shouldn’t lazily make pre-determined decisions and allow their investments to be influenced by “confirmation bias”
Confirmation bias refers to the human tendency to gather information that confirms a pre-existing belief or viewpoint. This may lead your clients to skip over taking the time to research their investments properly and simply rely on a piece of information that supports a decision they were already in favour of making.
In investing, this bias can lead to investors being blindsided by negative outcomes, especially if they believe an investment is a “sure thing”.
It is important your clients don’t rush into investments. They should consider doing thorough, unbiased research before reaching any final decisions.
6. They shouldn’t lust after quick cash while ignoring the risks coming from “incentive-caused bias”
Rewards and incentives can have a great degree of sway over human behaviour, this effect is known as “incentive-caused bias”.
Warren Buffett once described its effect by saying: “Nothing sedates rationality like large doses of effortless money”.
If your clients are enjoying the highs of sizeable short-term returns on investments that have ballooned to massive valuations, despite being overpriced compared to the cash they are likely to generate in the future, they may hold onto their investment for too long.
Working with a financial planner can help keep your clients level-headed and aware of when it’s time to say goodbye to the incentives before they’re outweighed by the risks.
7. They should avoid biting off more than they can chew by chasing losses and falling victim to biases like the “gambler’s fallacy”
The “gambler’s fallacy” is derived from the incorrect assertion, often held by individual’s chasing gains, that events that have occurred frequently in the past are less likely to occur again in the future (or vice versa) despite statistical data to the contrary.
For gamblers, this might involve believing that if a roulette ball has landed on red multiple times in a row, it’ll be more likely to land on black next. For investors, this may involve looking at market trends and assuming that if the market has been continually dipping, it is certain to rebound shortly.
This can push investors to throw good money after bad in the hopes of predicting the market or chasing down potential losses they’ve already made.
Your clients should know when to stop investing and realise enough is enough. They should avoid getting sucked into amplifying a small-scale problem and turning it into a much bigger one.
Get in touch
Billy Sunday, the baseball player turned minister, once wrote: “Temptation is the devil looking through the keyhole. Yielding is opening the door and inviting him in”. If your clients fall foul of investing biases, they might end up harming their long-term plans.
By seeking sound advice, they can navigate any potential issues, and ensure their plans remain on track. A good first step might be to contact us at info@grey-parrot.co.uk or call us at 02039 871782.
Please note
This article is no substitute for financial advice and should not be treated as such. To determine the best course of action for your individual circumstances, please contact us.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
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