By Kyle Grenier
Investors often have behavioural biases that can lead to flawed decisions and choices. Being aware of these biases can help you make better investing decisions and achieve your financial goals.
When making important decisions, we start with the information available to us now and rely on our experiences, education, and intuition to come up with the best answers. When we don’t immediately have the right information, or too heavily weigh the wrong factors, decisions may not work out as expected.
In Canada, public companies from a range of industries have corporate offices or production facilities in smaller cities and towns. In such areas, the company is often the main employer and a major contributor to the region’s economic well-being. Employees and their neighbours often purchase shares in the company for reasons that include their familiarity with the company, the good things it does for the community, and sometimes because many local people talk about the company.
The resulting high level of share ownership in the area is evidence of confirmation bias and, perhaps, home bias. These biases can increase risk because the decision to invest is based more on local information than on the prospects for the company as a whole.
Our biases are shaped and reinforced by our experiences. People who have similar characteristics, such as age group, gender, or economic background, tend to demonstrate similar biases.
How we go through our investment decisions and the emotional ups and downs that result from changing market values depend largely on our behavioural biases.
Market movements and bias
It would be nice if investments grew at a steady, predictable rate over the long term. Unfortunately, markets go up and down and sometimes stay relatively unchanged. How savers and investors react to these changes can depend on their investment approach. A recent quantitative analysis examined why many investors do not achieve the investment returns they expect, and noted that investment results depend more on investor behaviour than on how funds perform. Benjamin Graham, an investor and a professor of finance who influenced the investment strategies of Sir John Templeton, Charlie Munger, and Warren Buffett, said that the investor’s chief problem – and even his worst enemy – is likely himself.
How we go through our investment decisions and the emotional ups and downs that result from changing market values depend largely on our behavioural biases. When markets are going up we tend to buy in, and when they are in decline, fear can lead us to premature selling.
Overcome bias with a portfolio approach
Adopting a portfolio approach to investing can address these biases. A portfolio approach spreads investments out over a number of areas so that you don’t have all your eggs in one basket. Risk is reduced through a more diversified portfolio, and owning a greater variety of securities helps to reduce attention bias. Home bias can also be reduced by specifically including regional representation beyond locally known companies. Disposition bias is addressed by looking at how the portfolio functions as a whole so that selling a single poorly performing security is less of a concern.
Follow a wealth planning strategy
The reasons we choose to invest our savings are very personal. We often invest so we can afford a comfortable retirement lifestyle. We also invest to achieve other goals, such as home improvement, buying a car, a special vacation, or to help children or grandchildren with their education.
Including your goals in a well-constructed wealth plan gives you a better idea of how much you should save and how your investment choices can affect how your portfolio can grow. Depending on your current investments and your ability to save, you may be on track to achieve your financial goals or you may have already attained them by following your wealth plan. When this happens, the need to earn a specific return may be reduced, allowing the focus to shift from actively seeking growth to reducing risk to preserve your investments for your long-term personal goals.
A wealth plan is designed to balance your ability to save with the investments you need to make to achieve your personal goals. While the return you earn on your investment portfolio is always important, investing is the means to achieving your goals, and returns should not be the ultimate goal. Focus on your long-term personal goals, rather than the regular movements of your investments. When a plan is on track it is easier to be more confident about your financial future.
Working with a financial professional can reduce the negative impact personal biases have on your investment portfolio and thus your ability to reach your financial goals. Having a plan can protect you from some of the biases described in this article creeping in when information is complex or decisions involve risk or uncertainty.
Confirmation bias is best addressed by looking for and considering alternative scenarios or options. Seek information and research from a variety of sources that explains differing investment points of view. Considering alternatives to your initial investment beliefs may allow you to be more objective.
Disposition bias can be reduced by thinking about when to sell a security when making the original purchase decision. In a well-constructed portfolio, these decisions have to be made regularly as newer investment ideas and strategies replace older ones. With your advisor, assess the need to make changes to keep your investment portfolio on track.
Representativeness bias often manifests when chasing a long-established investment trend. Looking at future prospects for investment choices instead is wise as past performance is not necessarily a good indicator of future results.
To save and invest effectively, it is important to overcome behavioural biases that influence rational decision-making. Staying on track to meet your financial goals will be easier if you address behavioural biases that you may not realize are influencing your investment decisions.
Reducing the impact of your personal biases can help you achieve a better risk-reward balance when saving and investing for your future.
This publication is for informational purposes and should not be construed as professional advice. Individuals should contact their BMO representative for professional advice regarding their personal circumstances and/or financial position. The information contained herein is based on material believed to be reliable, but BMO Wealth Management cannot guarantee this information is accurate or complete. BMO Wealth Management is the brand name for a business group consisting of Bank of Montreal and certain of its affiliates, including BMO Nesbitt Burns Inc., in providing wealth management products and services. If you are already a BMO Nesbitt Burns client, contact your investment advisor for more information.
First published in the September 2018 edition of The Business Advisor.