Bias in Investing

How to Overcome Behavioural Biases That Could Ruin Your Investment Success

Helping our expat clients make the best decisions for their money is an essential part of our job as senior financial consultants in our full-service financial planning and investment management. Our intention is to assist clients in reaching their financial objectives in a manner that is convenient for them.

Recency bias, loss aversion, and procrastination (together referred to as status quo bias) are all examples of human behavioral biases that can get in the way of providing effective service to our clients. Let’s talk about some extremely typical blunders and then go through some strategies for avoiding them so that your portfolio continues to grow.

Investing research that focuses on the role of investor psychology is growing in popularity. Researchers who laid the groundwork in this area have been awarded the Nobel Prize in recognition of the profound impact of their work. Economists think about what people ought to do. Psychologists keep an eye on their actual behavior. How people make financial and other important life decisions in the face of uncertainty has been well praised.

Consider whether you have, in the past, engaged in any of these actions when dealing with your own finances.

Recency Bias

Recency bias occurs when one tends to think that recent events will be repeated or will persist into the future. We can think of two recent instances of this sort of thing happening with clients. In 2021, for example, investors flocked to buy technology stocks because they thought the market would continue its upward trajectory. It encouraged speculation, which, in our view, was already out of line with the underlying value of stocks.

The second time this happened was only last year, when the exact opposite occurred. Almost all major financial markets had sharp drops, leaving investors nervous and fleeing equities out of fear that recent poor performance will continue.

It’s tempting to cave into recency bias and “run for the hills,” but doing so is unlikely to be productive. The best strategy is to think long-term and remain committed to your current allocation. This could have vastly different implications for various investors. What matters is that it fits in with your risk appetite and your long-term objectives. At Expat Wealth At Work, we help our clients establish this kind of strategic allocation.

For successful investing over the long term, it is not enough to just set up a strategic allocation; one must also have the discipline and, at times, the fortitude to stick to it. In our experience, clients tend to overestimate their risk tolerance in good times and underestimate it in bad ones. The takeaway: Knowing how much you are willing to risk is crucial since second-guessing yourself can be expensive.

Loss Aversion

People tend to react negatively to losses rather than gains, a psychological bias known as loss aversion. It has been measured, and it has been found that the perceived agony of loss carries roughly twice as much weight as the perceived pleasure of gain. This reluctance can lead investors to try to time the market, hold all their money in cash, or take on an overly cautious asset allocation strategy.

Getting out of the market when things look bad, or maybe at the first symptoms of a fall, waiting on the sidelines, and then getting back in when things appear quiet, is a reasonable reaction.

However, in practice, during times of great volatility, the worst market days tend to occur quite close to the best days. Avoiding losses in the near term is impossible for any investor, whether professional or amateur, and attempts to do so might really do more harm than good to a portfolio.

What are our next steps, then? Investors struggling with loss-aversion bias typically feel helpless unless they do something. Moreover, as was previously mentioned, trying to time the market is not a sound strategy because investors can do little to prevent their short-term losses. Therefore, why not center our attention on what we can influence?

Many of our clients coming towards retirement may be taking more from their portfolio, so they believe that they should discard the investing plan that they had in place for years and pivot to focus completely on income and principal protection in their portfolio. However, in practice, the time horizon remains very long—maybe several decades—for people approaching retirement today. Retirement investors should concentrate on the long-term, foreseeable threat of inflation, which reduces the purchasing power of their investments, rather than worrying about short-term market fluctuations.

The persistently high rate of inflation has been the subject of much media attention. However, even at lower amounts, such as 2%, the effect is significant. We work with clients to help them recognize these forces in action and resist the instinct to shield themselves from potential harm. We suggest fighting the natural tendency to avoid loss and keeping a diverse portfolio that includes growth investments throughout life, even retirement, to protect against the long-term effects of inflation. Although they are vulnerable to short-term decreases, we believe that the growth they can generate will more than make up for the risk of short-term losses and will help to mitigate inflation.

Prejudice in favour of the status quo

Finally, procrastination and inertia are sometimes used to characterize the status quo bias behavioral component. In this context, “status quo” refers to the desire to keep things as they are. Another facet of the same coin is the aversion to doing anything that might alter the status quo.

The truth is, however, that people’s requirements evolve with time, necessitating periodic reviews of both their investment portfolios and their overall financial plans. Therefore, while we do recommend keeping a long-term horizon when investing, this does not give you license to bury your head in the sand. You should periodically rebalance your holdings to take advantage of changing market conditions. We take a methodical yet proactive approach to managing our clients’ portfolios, with an eye towards both fundamentals and valuations.

Let’s think of life insurance as an example of the status quo bias or inertia we’ve been discussing. Perhaps you’ve always been financially responsible and wanted to protect your loved ones in the event of your untimely demise. Perhaps you’ve got a big mortgage with 20 or 30 years left on it. Perhaps you have young children for whom you want to provide a college education. Perhaps your spouse or partner stays at home and doesn’t make as much as you do.

Let’s skip ahead to the present day. You may have put away a sizable amount of money for your children’s education or paid off most of your mortgage. All these changes suggest that you now require less insurance than when you first bought it. As we can see, it’s important to keep coming back to financial planning and not let inertia and procrastination get the best of us.

Explore Further

Whenever you need assistance identifying and overcoming behavioral issues that may be threatening your financial security, Expat Wealth At Work is here to lend a hand. We encourage you to contact us with any questions you may have about financial planning, as we recognize that the needs of each client and prospect are different. If you want to make the most of your portfolio, we can assess your situation and suggest strategies to prevent frequent mistakes.

Schedule some time for a free, no-obligation consultation.