Avoiding emotional investment biases

With current concerns over the uneven state of the global economy, turbulence in China, the direction of interest rates, and the price of oil (to name just a few issues), the risk emotions may unduly influence investment decisions may run especially high.

In our view, short-term market events and the emotions they can trigger should not drive investment choices. But how, exactly, can these factors be acknowledged while maintaining a proper focus on long-term goals and investment strategies?

For financial professionals, today’s environment demands a renewed focus on “softer” skills such as managing behaviour as a complement to the traditional focus on investment strategy.

Emotions drive biases and shape frames of mind in significant ways, and this holds true for a range of investors. The challenge is to identify and address biases before they exert undue influence on the investment decision-making process.

Here, we identify a more constructive approach by analysing five common behavioural biases that are rooted in emotional reactions and present potential solutions for each:

• Unrealistic expectations: Ensuring realistic expectations for investment returns

• Loss aversion: Identifying appropriate risk levels and the “highest acceptable loss”

• Familiarity bias: Striving to reduce “home country bias” and overreliance on the familiar

• Anchoring: Avoiding undue emphasis on a single point of reference, such as a stock index

• Overconfidence: Learning to respect the limits of one’s knowledge or investment strategy

Challenge 1: Unrealistic Expectations

Goal: Ensuring realistic expectations for investment returns – and avoiding pitfalls such as recency bias

Definition: Recency bias is the tendency to believe that recent trends will continue into the future. Confirmation bias, which is sometimes called expectation bias, is the act of interpreting or searching for information which fits one’s preconceptions.

We believe a clear and concise philosophy behind the construction of portfolios can help prevent high turnover and other destructive behaviours

After years of stellar returns in stocks and bonds following the financial crisis, investors’ expectations may exceed what today’s markets are capable of delivering.

Lofty expectations may be reinforced through selective consumption of financial media or other sources whose content fits or reaffirms pre-existing beliefs.

Often, unrealistic investment views are not closely examined until a stock-market decline, a sharp interest-rate increase, or a wave of defaults. However, market drawdowns historically have been commonplace; expecting the future to be different is likely to lead to disappointing results.

It is essential to identify the dangers of unrealistic investment expectations before markets force a reassessment, especially when it comes to extrapolating past performance into the future.