Profit by overcoming investment biases

Financial behaviourists have identified well over 20 investment biases that can tempt or lead individuals to invest in a particular way. Generally speaking, none of the biases is good news for investors.

Fortunately, investors who have an advisor aren’t vulnerable to making poor decisions out of fear, hope or any number of irrational reasons. However, understanding investment biases is still valuable. You’ll gain insight into portfolio decisions and better appreciate why not all investments hyped as winners are good opportunities. Also, certain biases, such as loss aversion and mental accounting, may affect any individual’s decision-making.

Here are several investment biases that a great many investors encounter.

Herd behaviour

Following the crowd may seem especially comforting and reassuring when our money is at stake. The thought is, “If so many people are choosing this investment, it must be a winner.” However, the herding instinct can lead to problems in various ways.

Jumping on the bandwagon may mean that you stray from following an investment plan. When you choose an investment on impulse, it may not be aligned with your risk profile, time horizon or financial objectives.

When herding arises out of the fear of missing out, individuals might chase a popular investment that’s hot and on an upswing—whether it’s a stock, fund or something new such as cryptocurrency. The trouble is, you’re now buying when the investment is more expensive. In addition, there’s always the chance that this year’s outperformer will be next year’s underperformer.

Mental accounting

With mental accounting, an individual values money differently depending on its source, and this may lead to unsound investment behaviour and decisions. Say that someone knows they should be paying their credit card debt or building their Tax-Free Savings Account (TFSA), and they receive their tax refund. Ideally, they should view the refund as rightfully earned money they can apply to their debt or TFSA—not as free money to spend on a luxury item.

Home country bias

A person negatively affected by home country bias holds so much of their equity portfolio in domestic companies that they sacrifice the full benefits of diversifying in foreign equities. It’s a global phenomenon, and Canada is a prime example of a country where home bias can deprive individuals of investment opportunities. First, Canadian stocks account for only about 3.4% of the global equity market.1 Second, the domestic market doesn’t offer optimal exposure to all sectors. The Canadian equity market is overweight relative to the global market in the energy and financial sectors, but underweight in the healthcare, information technology, consumer staples and consumer discretionary sectors.

Loss aversion

According to financial behaviourists, the degree of pain most people experience from a financial loss is much greater than the degree of joy felt from a financial gain. This aversion to loss can lead some individuals to make questionable investment decisions. For example, think of investors who sold investments or stopped making contributions when COVID-19 first hit and markets plummeted. They would have missed one of the fastest market recoveries in history.

It’s only human nature to be affected by investment biases at one time or another. If you ever feel you should react to changing market conditions or new investment opportunities, talk to us and we’ll assess the situation together.

Biases most affecting investment decisions

Poll results of 724 chartered financial analysts from around the world naming the most common bias among investors.

 

Source: CFA Institute survey, “Which of the following behavioral biases affects investment decision making the most?,” 2015.

 

¹ Vanguard, “A Case for Global Equity Diversification,” 2023.