Being good at investing does not come naturally to humans. Successful investing requires taking risk and most of us lack the inbuilt ability to think rationally when dealing with risk.
Researchers have long known that humans are susceptible to having irrational tendencies when investing and we call these biases. Biases are when we don't think logically which distorts our ability to make rational decisions based on objective facts and evidence.
Many biases are deeply rooted in emotion, and this is especially true for inexperienced investors, and they increase our tendency to act irrationally when we are thinking about or experiencing risk.
The degree to which someone falls victim to their investment biases varies greatly between individuals and is highly dependent on both their personality and past experiences.
Biases will affect your investing decisions and the consequently the outcomes you experience, and therefore understanding and managing your biases is key to becoming a successful investor.
There are a lot of biases but the one I have observed most often is called Loss Aversion Bias.
As its name suggests, it describes the fact that humans tend to be more sensitive to losses than to gains. We tend to feel the pain of losses far more than the joy of gains. As a result, we tend to do more to avoid losses than to acquire gains. This can cause investors to take on less risk than they ideally should but ironically, it can also cause the investor to make riskier moves for the sole purpose of mitigating expected pain. Weird isn't it!
Loss Aversion Bias can cause investors to delay investing trying to time the market, to sell solid investments when the markets go down or even avoiding selling bad investments because then the loss becomes "real".
It may also cause investors to put more weight on bad news and less weight on good news, which will impact how you react in a declining market, potentially leading to panic selling when a rational and cool head is required.
Arguably and more importantly, many investors spend way too much time thinking about and preparing for crashes and "corrections" that may not arrive for years. This could be in the form of sitting on cash to try to time the market or investing in more conservative investments with a much lower expected return. Hindsight sometimes proves that at some points in time these have been a reasonable short-term strategy but more often than not, the long-term negative consequences have been significant.
Legendary investor Peter Lynch famously said, "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."
Being aware of Loss Aversion Bias is the first step in lessening its impact on your investment success. Do your research and educate yourself, pick an investment strategy that suits your risk tolerance and time horizon, review and rebalance your portfolios regularly and ignore short-term noise and stay the course. But above all take action as no one ever won a game sitting on the sidelines.
