Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
No one likes making mistakes. Especially when it comes to investing. That’s why it’s important to have an investment strategy which is based on a series of questions. Like, what are your financial goals? How long do you want to invest for? What are your personal and financial circumstances? How comfortable do you feel about risk?
But that’s not all you need to ask yourself. These are simply the easy-to-get-your-head-around known pieces of information that you need to be aware of to make investment decisions that are right for you. But what about the unknown built-in biases that shape our decisions?
This is where a little science can help. Behavioural scientists have long identified a range of investing biases - from confirmation bias to status quo bias, herd bias, representative bias and more. I’ve whittled the list down to three that I feel have the potential to cost you money. And then, because forewarned is forearmed, there are some practical steps you can take to lessen the impact these biases have on your investments.
1. We fear losses more than we like gains
This fear - otherwise known as loss-aversion - really speaks to me. Over the years there have been times when the value of my investments has significantly dropped and I’ve felt quite ill at the thought. Equally, there have been times when the value of my portfolio has been significantly up.
And while these gains have put a little spring in my step, I’ve not been deliriously happy. My reaction to losses is simply not equal to gains. And it’s an aversion that often convinces people to save, rather than invest, even when inflation erodes the value of their savings over time (a bird in the hand is worth two in the bush and all that).
The fear of loss can hold us back in so many ways, from finding a new job to starting a hobby. With investing - as with life - this fear can be costly. It’s a dynamic of evolution. As the economic psychologist Daniel Kahneman put it in Thinking, Fast and Slow: “Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”
The solution? Invest for the long term - and then look away. If you fixate on the ups and downs, you’ll acutely feel the losses and may sell. And the longer you’re invested, the lower the chances are that you’ll make a loss, although this isn’t guaranteed. Take a look at the chart below, which is based on the US S&P 500 stock market.
Let’s say that you invest in shares for one year. Over this time, you could expect - based on history - an annualised return which ranges from around -40% to +60%. However, if you invest for five years your likely annualised return narrows to between -5% and +30%. Stay invested for 20 years and the data shows that your annualised return would range from +5% to +10%. In other words - the longer you’re invested, the more confident you can be that your return will be positive. Please remember past performance is not a reliable indicator of future returns.
Source: Refinitiv, S&P 500, total returns in US dollar terms - 31.12.82 to 31.3.23, annualised returns based on 1 yr, 5yr, 10yr and 20yr periods starting at one month intervals.
2. We unknowingly label winners and losers.
The technical term for this is disposition bias and it’s closely linked to loss aversion and that’s why it’s next on my list. It describes an investor’s tendency to hold on to assets that are decreasing in value (losers) too long and sell investments that are gaining in value (winners) too soon. And that’s because we’re more willing to acknowledge gains than we are to acknowledge our losses.
I confess, I’m naturally more of a funds girl. But during Covid I decided to invest in a small number of companies that piqued my interest. Two of them were Tesco and Rolls-Royce. I’ve marked the point at which I bought them. As you can see, they tell very different stories with Rolls-Royce providing me with an infinitely smoother emotional roller-coaster ride than Tesco.
The risk is that I label Rolls-Royce as a forever winner and Tesco as a loser. And, as a result, I end up holding one longer than I should and sell the other prematurely. There was a timely reminder this week as to why this bias has the potential to be damaging. Earlier this week Tesco upgraded its profit forecast for the year after posting a jump in pre-tax earnings in the first six months. Shares rose by 4.3% on the day following the announcement.
Tesco share price
Source: Fidelity International, 1.10.18 to 1.10.23. Please note that past performance is not a reliable indicator of future returns.
Rolls-Royce share price
Source: Fidelity International, 1.10.18 to 1.10.23. Please note that past performance is not a reliable indicator of future returns.
I know how difficult it is to time the market, so I’m not one for watching these rises and falls too closely - or reacting to them too quickly. I’m in it for the long term. As for what I’m planning on doing with my Tesco and Rolls-Royce stock… ask me again in a year.
3. We feel safer investing in what we know
Investing guru Peter Lynch was famously quoted as saying that investors should invest in what they know, but it’s a quote that’s often taken out of context. He didn’t mean that we should invest in something simply because we’ve heard of it. That feels more like gambling. What he meant was that we should draw on our own expertise - perhaps the sector we work in - to research what we choose to invest in more deeply.
But this idea of ‘investing in what you know’ (or what we feel comfortable with) is a bias that investors can - and do - fall foul of. It’s known as familiarity bias. And if investors aren’t aware of this bias, they run the risk of not having a well-diversified portfolio - which could lead to increased volatility on the journey.
One common manifestation of this is home bias, where investors are more inclined to back their domestic market rather than to invest more globally. A survey reported by Thisismoney, a financial news website, found 74% of UK investors put the majority of their money in the UK.1
The patchwork quilt of investment returns, below, underlines the benefits of diversification. You can see that if you’d only invested in the UK over the last 25 years, you’d have had a rocky ride.
What can you do to help reduce the impact of your biases on the value of your investments?
1. Invest regularly
Investing regularly is worth considering for a couple of reasons. The major one is that it helps take the emotion out of making decisions (like with disposition bias above). But it can also help average out the cost of your investments over time. You can read more about how investing little can help you here.
2. Manage risk
It’s important you understand and manage risk. Investing isn’t about avoiding risk, it’s the foundation on which investors potentially grow their money. It’s about taking the right risks, watching out for pitfalls (like inflation) and spreading the risk. You can learn more about how to manage risk here.
3. Think about financial advice
If you’ve got a large portfolio, or particularly complex financial needs, you may want to talk to a financial adviser. They’ll take time to understand your circumstances and get to know you before coming up with a personal financial recommendation. The first step is a free no obligation chat. So, if you’re wondering if this suits you, why not get in touch? You can find out more about financial advice here. Or request a call back from a financial adviser here.
Five-year performance table
|
(%) As at 4 Oct |
2018-2019 |
2019-2020 |
2020-2021 |
2021-2022 |
2022-2023 |
|---|---|---|---|---|---|
|
Tesco |
13.9 |
-7.9 |
50.8 |
-13.0 |
34.8 |
|
Rolls Royce |
-23.6 |
-84.3 |
264.7 |
-47.6 |
183.1 |
Past performance is not a reliable indicator of future returns
Source: FE, as at 4.10.23 Basis: Total returns in GBP. Excludes initial charge.
Source:
1 This is Money - Is 'home bias' costing you dear in your investing?
Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Direct shareholdings should generally form part of a well-diversified portfolio of other investments. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.
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