Becoming aware of these 3 behavioural finance biases can help your investment profits

Every investor has to live with all-too-human tendencies that influence our decision-making. You have these tendencies for a reason, but sometimes that reason works against your investment goals. To succeed as an investor, you need to recognize these behavioural finance biases, and take control of them.

Investing behavioural finance bias #1: Reaction to danger.

This is one of the oldest human tendencies. It goes back to the millennia that our ancestors spent on the African savannah, hiding from saber-toothed tigers and other megafauna, not to mention marauding neighbours. To stay alive, we learned to keep a constant eye out for danger, react quickly, and run fast at the first sign of trouble. Over many millennia this has become one of many behavioural finance biases.

False alarms were frequent, of course. But the odds favoured running at any hint of risk. If we ran, we stayed alive, and at times we happened upon a new berry patch, a bird’s nest full of eggs, or a small rodent for our next meal.

Investors have at least some natural tendency to react the same way to modern financial danger signals such as news or predictions of interest rate increases, market downturns, strikes, layoffs, scary political news and so on.

Here too, false alarms are common. Yet at one time or another, all investors react by selling their best stocks way too early. Sometimes, they plan to buy them back when the situation becomes clearer, or the danger is passed. The trouble is that you may get the strongest urge to sell just when the market is close to a bottom.

Investing behavioural finance bias #2: Cognitive dissonance.

You might see this as the opposite of excess wariness. It’s common, for instance, when shopping for a new car. Suppose you are trying to decide between a Ford and a Chevy. You’ll probably read articles about the pros and cons of the two brands, visit showrooms, take test drives, ask friends and so on.

Eventually, you’ll choose one over the other. Once you’ve made that decision, you’ll probably spend less time reading car reviews. But chances are that you will continue to read unfavourable news or reviews of the car you rejected, while remaining open to news or reviews favourable to the car you chose.

A psychologist would say you do this to avoid the unpleasant state of “cognitive dissonance” (non-professionals refer to it as “buyer’s remorse”). This is the gnawing fear that you made the wrong choice and should have spent more time shopping. Or you may fear you spent too much money, or that the salesperson took advantage of you.

This is also sometimes referred to as the “buy in haste, regret at leisure” syndrome. The best cure for it is to expose yourself to people or materials that applaud your decision…or to just quit thinking about it.

In the world of behavioural finance biases, this human tendency is sure to cost you money one day, if you take a casual, buy-and-hold approach to investing. All too often, “buy-and-hold” turns eventually into “buy-and-forget.”

That’s why we stress that you need to follow our three-part Successful Investor approach to building a portfolio. Then you need to apply a “buy-and-watch-closely” approach to each of your investments.

Investing behavioural finance bias #3: Appeal of the new.

At some time in their lives, many people feel a near-automatic attraction to things that are new or different. That’s why the food, fashion, music, TV and other industries thrive by regularly introducing new products.

People get used to the idea that it’s good to try something new. They get used to the idea that you can largely take advertising claims and glowing reviews at face value. However, when assessing financial commitments, those same attitudes are dangerous.

When it comes to behavioural finance biases, the problem is that the risks in bad investments are subtle—far easier to overlook than, say, a tiger’s snarl. That’s especially true of aggressive investments. Sometimes, the story is so good that success seems guaranteed, if you just hold on long enough.

For instance, investors may ask if a particular new stock issue or unproven tech stock or penny mine is a good choice for an RRSP. We explain that these investments are too risky for an RRSP. Some reply, “I don’t mind the high risk, because I plan to hold for the long term.”

They have it backwards. Well-established companies with a history of sales and profits, if not dividends, are your best choice for long-term investment success. They tend to survive the bad times and go on to thrive anew when good times return, as they inevitably do. You put the odds in your favour even more if you use our three-part strategy to build a portfolio of well-established companies.

The reverse is true of companies whose main appeal is that they have come up with something new. Most new private companies eventually fail. The risk is even worse with public companies. For every Facebook or Google, there are a million duds.

We encourage all TSI readers and subscribers to become aware of their own behavioural finance biases and of the market in general. This skill alone can teach more about how to profit from the market long-term than any other skill. Share your experience with us in the comments.