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Cognitive Biases: awareness can help investors avoid mistakes

9 September 2020 |Investor insights
Learn how unlocking the value of your investment portfolio using a margin loan can help build wealth and achieve your financial goals on a chart background.

Cognitive Biases: awareness can help investors avoid mistakes

9 September 2020 |Investor insights

Investors are facing complex decisions in response to current market fluctuations. Success won’t come from knowing more – predicting the market can be difficult, even for professionals like yourself. Success will depend on how you can support your clients to make decisions in the face of uncertainty and to resist acting on emotions. Helping them be aware of their cognitive biases is the first step to them making rational investment decisions.

Most mistakes stem from loss aversion

When it comes to investing, our grandparents had one thing right; don’t put all your eggs in one basket. But the quip ‘a bird in the hand is worth two in the bush’ may sound wise but is not sage investment advice.

It is human nature to want to hold on to what we have. We are biased towards the status quo. And most people will go out of their way to avoid a loss. They will even run away from the potential to earn an equivalent gain.

That is loss aversion. Humans feel more hurt from losing ten dollars, for example, than they feel pleasure from getting ten dollars. Typically, the potential gain must be twice as large as the loss to overcome our perceived sense of pain and anxiety.

A preference for the status quo and a degree of risk aversion was an evolutionary advantage. A caveman only survived by not straying too far from the familiar. Today, being suspicious of investments promising improbably high returns is similarly prudent. But a considered risk assessment is not the same as the more insidious loss aversion. Overcoming loss aversion starts with framing your choices.

Cognitive biases follow the market’s fluctuations

Clients can be reluctant investors because investing requires actions and decisions. Add a good dose of loss aversion to this natural inertia, and they tend to be comfortable with procrastination.

One sure cure for procrastination is FOMO – the fear of missing out. As markets show a strong upward trend, for example, everyone gets over their inertia and jumps on board. There are many examples of asset price bubbles, irrational exuberance and a recent example of investors not even stopping to check simple details before jumping into the wrong technology stock.

When bull markets turn, investors’ unconscious biases get a real workout. They can anchor, endow, shield or all three along with loss aversion, procrastination and a host of other decision shortcuts.

The advertisement offering a $100 gadget for the one-time, special price of $50 is familiar. The $100 is an anchor, it convinces consumers of the gadget’s inherent value and that $50 is a bargain.

Investors can do something similar. Investors anchor their assessment about future performance on their initial purchase price instead of the investment’s intrinsic value. Such investor may hold onto a losing investment believing it must return to its anchor level.

Human beings also tend to endow an object they own with a higher value than the item is worth. Adding sentimental value to a symbolic family trinket is enjoyable. Adding sentimental value to investments can lead to irrational financial decisions. Clients may become hoarders.

Investors also tend to actively seek only information that supports their views and opinions and shield themselves from any contradictory information. This bias can lead to overconfidence because everything they hear or read seems to confirm their beliefs.

Finally, humans are still loss-averse procrastinators. No matter the weight of objective evidence, some investors will only sell at a loss if backed into a corner like needing cash. But if emotions have driven them to exit an investment, then it can be even harder to overcome their natural cognitive biases when markets recover.

Being cautious at times of heightened uncertainty and falling markets is reasonable. But the best upside potential is after a market crisis as the bear market begins to turn fretfully. Investors will need rational decisions and clear actions to seize the opportunity.

Optimising for Emotions

Economists believe in ‘homo economicus’: the always rational investor. The rest of us are human beings with hardwired emotions that shape our decisions. Instead of fighting against their nature, investors should make their emotions work to their financial benefit.

First, they should focus on the why. What goal are clients striving to achieve: saving for a home, a holiday, an education, financial security or a comfortable retirement? Then they can reframe their choices. Instead of giving into fear by listing the perceived risks of investing, they can apply FOMO to their goal. What are the broader risks of missing their goal, either by doing nothing or being more risk-averse than reasonable for their circumstances? It may be well worth them reaching for those two birds in the bush.

These questions can be emotionally challenging – loss aversion is about twice as strong as the desire to succeed. The value of professional advice is as a counterbalance to investors’ natural but often irrational tendencies.

If you would like any further detail about how Leveraged margin loans can support your clients’ financial goals, please contact your Leveraged Relationship Manager or call us on 1300 307 807.

Things you should know

Gearing involves risk. It can magnify your returns; however, it may also magnify your losses. Examples are for illustration only and are not intended as recommendations and may not reflect actual outcomes. Past performance is not an indication of future performance. The information provided in this document has not been verified and may be subject to change. It is given in good faith and has been derived from sources believed to be accurate. Accordingly no representation or warranty, express or implied is made as to the fairness, accuracy, completeness or correction of the information and opinions contained in this article. To the maximum extent permitted by law, no entity in the Group, its agents or officers shall be liable for any loss or damage arising from the reliance upon, or use of the information contained in this article.

Issued by Leveraged Equities Limited (ABN 26 051 629 282 AFSL 360118) as Lender and as a subsidiary of Bendigo and Adelaide Bank Limited (ABN 11 068 049 178 AFSL 237879). This information is correct as at the time of issue, and is for general information purposes only. It is intended for AFS Licence Holders (or authorised representatives of AFS Licence Holders) only. It is not to be distributed or provided to any other person.

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