By: Hannah Myburgh
Human biases—whether cognitive, emotional, or psychological—often result in suboptimal investment decisions. Cognitive biases, such as confirmation bias, stem from mental shortcuts we use to process information, which can cloud judgment. Emotional biases, however, arise when fear or desire impairs rational thinking. Both types of bias can undermine decision-making. As a long-term investor, it’s essential to recognise these tendencies and mitigate their influence to maintain clarity and discipline in your investment strategy.
Confirmation bias
Confirmation bias occurs when investors actively seek out information that validates their beliefs while disregarding evidence to the contrary. For instance, after making an investment decision, an investor might focus solely on opinions or articles that reinforce their choice, viewing it as rational and justified. This bias discourages critical examination of assumptions or decisions, often as a way to avoid cognitive dissonance—the mental discomfort caused by conflicting information. Additionally, this selective information gathering can lead to overconfidence, where investors overestimate the soundness of their decisions, potentially exposing them to unnecessary risk or poor investment outcomes. Recognising and challenging confirmation bias is vital for sound decision-making.
Over-confidence bias
Overconfidence bias occurs when investors overestimate their abilities and control over their investment decisions. This is often evident when individuals believe they can outperform experienced portfolio managers or multi-managers, despite evidence suggesting otherwise. Overconfident investors frequently trade more actively, which, paradoxically, often results in poorer investment returns. Recognising the limits of one’s expertise and seeking professional guidance can help mitigate the risks associated with this bias and improve long-term outcomes.
Information bias
In today’s age of continuous information flow, investors often fall victim to information bias, where irrelevant data influences their decision-making. With live-streamed updates and minute-by-minute market commentary, it’s easy to mistake noise for valuable insight. This bias can lead investors to make impulsive decisions, such as altering strategies in response to short-term market fluctuations, even when their objectives are long-term. Staying focused on a well-structured investment plan helps avoid being derailed by unnecessary information.
Loss aversion or regret aversion
Loss aversion often prevents investors from recognising the opportunity costs of staying invested in underperforming assets. It’s akin to clinging to a problematic car after expensive repairs, even though it continues to break down. While cutting losses and moving forward is sometimes the best course of action, those influenced by loss aversion tend to hold on, hoping to recover their investment. This behaviour can result in missed opportunities for better strategies. Moreover, the longer an investor maintains this position, the harder it becomes to switch, potentially compounding the financial impact over time. Recognising this bias is essential for sound decision-making.
Hindsight bias
Hindsight bias creates the illusion that past events were more predictable than they actually were, leading investors to overestimate their ability to predict future events and fall into the over-confidence trap. While hindsight allows us to connect the dots retrospectively, hindsight bias skews this reflection by making investors believe they would have had the foresight to connect the dots in real time. This misconception can result in overconfidence and poor investment decisions.
Bandwagon effect
Investors who accede to the bandwagon or groupthink bias take comfort in knowing that there is a large group of people who hold the same belief. Rather than reaffirming their decision by using reliable data and analyses, investors prefer to depend on the idea that ‘everybody can’t be wrong’ as the basis for holding their investment position.
Anchoring
Anchoring occurs when investors rely too heavily on the first piece of information they encounter, using it as a benchmark against which all subsequent information is evaluated, rather than assessing it objectively. For example, imagine a seller receives an initial offer of R5 million for their home but rejects it. Months later, another offer of R4.8 million is received. Anchoring causes the seller to perceive the value of the property as R5 million, framing the lower offer as a R200,000 “loss.” In reality, this perceived loss is entirely relative to the initial anchor, underscoring the importance of evaluating offers without bias.
Investment markets are inherently cyclical, turbulent, and complex, often triggering emotional and cognitive biases in long-term investors. While these biases are unavoidable, learning to identify them is crucial. By recognising their influence, investors can mitigate irrational decision-making, ensuring their actions align with their long-term investment strategies rather than reactive impulses.
* Myburgh CFP® is a financial planner at Crue Invest (Pty) Ltd.
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