Two mental traps that could be affecting your investing
Even the most experienced investors can fall prey to subtle psychological traps.
These behavioural biases often operate under the surface, influencing decisions in ways that can undermine long-term investment success.
Here are two of the most common behavioural biases that may be affecting your investment results – and strategies for overcoming them.
Loss aversion: Why we feel losses more strongly than gains
Loss aversion is the tendency to feel the pain of losses more intensely than the pleasure of equivalent gains.
Psychologists Daniel Kahneman and Amos Tversky, the pioneers of prospect theory, found that a loss of $100 hurts roughly twice as much as the pleasure we get from gaining $100.
Loss aversion can lead investors to make sub-optimal decisions, such as:
- Panic selling when markets perform poorly.
- Being more willing to sell assets that have increased in value to lock in gains, while holding onto those that have decreased, a tendency known as the disposition effect.
- Preferring lower-risk, lower-return investments like cash over shares, which, while volatile, may tend to perform better over the long-term.
For example, during a severe market event, it can be tempting to move to cash to avoid further losses. But it’s often not a wise move.
Research found that investors who moved their portfolios solely into cash for one year after a severe market event had an 87% probability of underperforming a 60/40 portfolio of U.S. equities and bonds, with an average underperformance of 13.3%.1
Recency bias: Extrapolating recent trends into the future
Recency bias leads investors to give more weight to recent events and less to historical patterns when making judgments and decisions.
For example, research shows that, when asked about their expectations for future market returns, investors are more bullish when markets have performed well over the last year, and more bearish when they haven’t
Recency bias can lead to behaviours such as:
- Chasing performance by buying into “hot” sectors or funds.
- Abandoning investment strategies or selling assets that have underperformed recently.
- Overreacting to short-term headlines or market moves.
For example, US investors were extremely optimistic about technology companies in the late 90s before the dot com bubble burst in early 2000, causing widespread losses.
What can investors do about it?
Behavioural biases like loss aversion and recency bias affect all investors. But having a sensible, evidence-based investment strategy can help.
Four principles of investing offer a framework for managing these biases and staying on track:
- Set your goals: Having a clear investment plan acts as a guide during uncertain times. It helps investors stay grounded and avoid impulsive decisions that may be influenced by bias.
- Stay well balanced: Building a balanced portfolio with a range of different assets can help reduce the impact of any single market event. That’s because the best-performing asset type one year can sometimes be the worst-performer in the next.
- Maintain perspective: Staying focused on long-term goals can help investors avoid overreactions to short-term news.
- Minimise your costs: You can’t control what the market does, but choosing lower cost investments means you keep more of your returns.
By recognising these behavioural pitfalls and having strategies to manage them, investors can be better positioned for long-term success.
1. Source: Vanguard total return calculations, as of 31 December, 2024. Equities in the 60% equity/40% fixed income portfolio are represented by the Russell 3000 Index and fixed income is represented by the Bloomberg U.S. Aggregate Bond Index. Cash is represented by the FTSE 3-Month Treasury Bill index. Monthly data are from January 1980 through December 2024. Equity losses of more than 10% over three months trigger the move from a 60/40 portfolio to all cash in the illustration.
Source: This article has been reprinted with the permission of Vanguard Investments Australia Ltd. Copyright Smart Investing
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