5 Investor Biases to Avoid When the Market is Volatile

In times of volatility, it is all too easy to be led by our emotions when it comes to investing. Investment decisions based on fear, greed and overconfidence in our own judgement are not likely to lead to the best outcome.

While most investors would not regard their dealings as emotionally-led, it is important to look at the biases many of us hold. Under the influence of these biases, emotional decisions can seem perfectly rational. 

When the market and the economy are in crisis mode, even the most logical-minded investor can be drawn into flawed decisions.

Here are the top five biases to be aware of (and to avoid) during volatile periods:

Loss Aversion

Loss aversion is an investor bias which places more value on potential losses than potential gains. Typically, the pain of losing money is significantly more powerful, and more lasting than the pleasure of gaining. This can lead to investors making poor decisions to try and avoid losses, even if this means missing out on gains.

An example of this would be rushing to sell investments when there is any hint of market volatility. This is not a good idea, for the following reasons:

  • If you have enough information to make the decision, it is already too late. Millions of other investors will have already had the same idea.
  • The risk of loss is already priced into the market, meaning that it is unlikely you will recoup the full value of your investments if you sell now.
  • The best days in the market often occur shortly after the worst. By withdrawing money, you may miss out on the recovery.

The best solution is to trust in the market and your investment strategy, remaining invested for the long-term.

Familiarity Bias

Familiarity bias is the tendency to favour investments with which the investor is more familiar, regardless of quality or suitability. This is one reason for the popularity of property investments, as most people understand bricks and mortar, but many are uncomfortable with the stock market.

In an investment portfolio, home bias is a fairly common sub-category of familiarity bias. Even professional investment managers can be guilty of this. While the UK only accounts for 5-10% of the world economy, it is not unusual to see portfolios holding substantially more in UK shares. This can cause the following issues:

  • Over-exposure to a single region, increasing the risks if anything goes wrong
  • Limiting the scope to invest globally in potentially higher-growth areas

Just because an investment is familiar does not mean it is inherently better. Of course, it is difficult to predict which investments will do well, particularly when the world economy is changing so quickly.

The key is diversification. Holding a wide range of assets, and committing to this for the long-term, can help to iron out biases, as well as the worst of the volatility. It also means the portfolio is in a strong position when the market starts to recover.

Overconfidence Bias

Overconfidence bias is the belief that our judgement is greater than it actually is. Whether trading shares, cryptocurrency or betting on horses, it is easy to believe we are privy to some insight that has escaped our competitors. 

Overconfidence bias stems from two main factors:

  • Optimism
  • The desire to feel in control

The effect is increased when judgement calls prove to be profitable. Decreased confidence arising from losses is usually only temporary.

The easiest way to overcome this bias is to delegate your investment decisions, removing your own judgement from the picture.

Groupthink/Herding Bias

Groupthink, or herd mentality, is not unique to investing, but arises when a group of people make poor decisions based on observing the behaviour of others. A world pandemic is the ideal breeding ground for groupthink as no one really knows what to expect or how to behave. 

In investment terms, groupthink can lead to following the crowd when either buying or selling an investment. For example:

  • More people buy an investment, leading to over-confidence that it has the potential to do well. This increases the share price, resulting in even greater investment. So it continues, until it becomes apparent that the share is over-valued and the price drops. This happened on a massive scale during the Tech Bubble in the early 2000s.
  • More investors sell an investment, creating concern and eventual sales, leading to a drop in share prices. Again, this effect is self-replicating, as further sales cause the share price to drop even more. This occurred during the 2008 Financial Crisis, and again at the start of the Coronavirus pandemic.

When you have a sound investment strategy, volatility is already planned in. You can avoid succumbing to groupthink by avoiding the financial press and sticking with the plan.

Information Bias

In today’s climate, we are bombarded by information, most of which we didn’t ask for. This may take the form of news articles, advertising features or the well-meaning advice of friends.

If you hear about a fund, company share or industry sector often enough, this can create a false confidence that it represents a good investment opportunity. 

Here are some questions to ask when considering a new investment:

  1. Why are you just hearing about it now? How has the investment performed over the longer term?
  2. How has the investment performed compared with its peers?
  3. What are the costs of accessing the investment?
  4. What is the vested interest of the person or organisation bringing you this information?

Proper under-the-bonnet due diligence is the only way to evaluate a potential investment and this is usually best left to professional investment managers.

It’s not easy to adapt to new ways of thinking, particularly when the stakes are so high. You can overcome investor bias by:

  1. Make investment decisions based on evidence, rather than emotion or bias.
  2. Align your investment plan with your financial plan. This will help you establish the returns you need, even accounting for volatility.
  3. Accept that investments are for the long-term and that short-term decisions are unlikely to be helpful. Keep an adequate cash reserve so that you don’t need to draw on your investments early.
  4. Aim for a diversified, all-weather portfolio that is positioned for any market outcome, rather than trying to second guess world events and how they will impact specific stocks.
  5. Avoid checking your investments every day. 
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Joe Jackson

Helping people achieve their financial goals is an extremely rewarding experience. No two clients are the same, which means no two days are the same. It’s a really fast-paced industry, full of characters and personal interaction, and I absolutely love it.