In a time of volatility, it’s easy for our emotions to take over our decision-making process. We have previously looked at the concept of ‘loss aversion’ – the theory that, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining – and why it can be so prevalent in uncertain times.
Over the next few months, it’s likely that markets and the economy will continue to face difficult times. As the UK heads for a deep recession, there is likely to be an impact on share prices, inflation and interest rates.
It’s also likely that you will experience some other behavioural biases as you try and negotiate this period. Here are five of the most common biases you’re likely to face, and how you can overcome them.
1. Confirmation bias
Confirmation bias is the human tendency to look for, interpret, and favour information in a way that confirms or strengthens our personal beliefs or hypotheses.
The way humans are wired means that we find it easier to understand data that confirms what we already think or know.
During uncertain times, individuals with a higher than typical confirmation bias will be much more susceptible to news and social media posts that do nothing but confirm their current fears and anxieties.
Investors are also susceptible to this bias as they tend to gather confirming evidence when making investment decisions rather than evaluating all available information. While there is nothing wrong with reviewing evidence that supports your investment philosophy, you should also make a significant effort to look for evidence that conflicts with your way of thinking.
The way to tackle confirmation bias is to keep an open mind and to understand all perspectives. This is what a good evidence-led investment strategy looks like.
2. Herding bias
As humans, we have a tendency to believe in the wisdom of crowds. Herding bias is where we rationalise that a course of action is correct because that is what everyone else is doing.
Herding comes from a basic evolutionary need to fit in with the majority. In the past, exclusion from the pack was dangerous as there would be less protection from predators.
Nowadays, this has become colloquially known as FOMO – the fear of missing out. From an investment perspective, you might be inclined to sell when everyone is selling and buy when everyone is buying.
In uncertain times, it can really pay to think independently and to base your decisions on your principles and values. This keeps you grounded, and stops you blindly following the herd.
3. Action bias
In difficult times, we sometimes feel as if we have to take action as it’s the only way that we can regain control over a situation. Sometimes, we simply take action to feel as if we are doing something.
Action bias is the tendency to act for reasons that are generally valid, but not in the specific situation. We tend to focus on the benefits of action and ignore the costs. Psychologically, even if acting and not acting result in the same outcome, that outcome feels worse when we didn’t take action.
In uncertain times, inaction is often the best course of action. It’s worth remembering that it takes conscious effort to not act, so not taking action is taking action!
If you’re worried, slow down, take a step back from your emotions, and home in on what really matters. If your financial plan is still on track to meet your goals, why do you need to do anything?
And if you feel you have to do something, take action where it counts. Keep an eye out for tax-saving opportunities, switch your cash savings for a better return, or capitalise on lower interest rates by moving your mortgage or credit.
Framing is a situation where you decide on something based on the way information is presented, rather than because of the facts themselves. Here’s an example:
- In Q3, our earnings per share were £1.13, compared to expectations of £1.15
- In Q3, our earnings per share were £1.13, compared to Q2 where they were £1.11
Here, the second version does a better job of framing the information. The way it is presented – as an improvement over the previous quarter – puts a more positive spin on the data.
If you don’t have all the facts, or you are in a situation where there are many unknowable factors, there is a high probability of reflexive decision-making. The probability of being influenced by framing bias is increased.
One way to tackle this bias is to always challenge the framing. Think about rephrasing the information you’re reading to see what impact, if any, that has on your conclusion.
Try to remove any editorial/judgmental commentary and look at only the key numbers and underlying assumptions. Then arrive at your own conclusions, rather than being swayed by how the information is presented to you.
5. The Semmelweis Reflex
Ignaz Semmelweis was a Hungarian obstetrician who discovered that ‘childbed fever’ could essentially be eliminated if doctors washed their hands before assisting with childbirth. He initiated a strict regimen at his hospital where everyone involved in birthing had to first wash their hands with a chlorinated solution. As a consequence, death rates plummeted.
Semmelweis expected a revolution in hospital hygiene because of his findings. But it didn’t come. This is because his hypothesis – that there was one cause of disease that could be easily prevented – ran counter to the prevailing medical ideology, which insisted that diseases had multiple causes.
His approach was largely ignored, rejected and ridiculed. He was ultimately dismissed from his hospital post and harassed by the medical community in Vienna, forcing him to move to Budapest where he later died in an asylum.
The point here is that investors can tend to reject new evidence or new knowledge because it contradicts established norms, beliefs, or paradigms.
To avoid this bias, it’s important that you consider evidence over ideology. Don’t just blindly accept established norms in the face of contrary evidence.
Ironically, the modern world is a great example of the Semmelweis Reflex in action, 160 years later. When we are told to wash our hands for longer to prevent an illness, we may be slow to accept the benefits as it isn’t what we believe is the ‘normal’ approach for tackling disease.
Get in touch
One of the roles of a financial planner is to act as a sounding board, and to help you avoid making knee-jerk decisions based on emotion. We’re here to help you to stay focused on your long-term plans and to ensure you’re not blown off course by acting on behavioural biases.
Find out how we can help you. Email firstname.lastname@example.org or call us on 01454 416653.