If you had to pick one lesson to live by, it might be “trust your gut.” That deep-inside-of-your stomach feeling has helped many of us choose between right and wrong, decide which career path to take, who to get into a relationship with and much more. Your gut, though, isn’t some magical body part – it tells us what to do based on our personalities and how we’ve reacted to different situations in the past. While our instincts do help us navigate our complicated lives, they can also lead us down the wrong path, especially when it comes to investing.
Everyone has patterns of thinking that can influence their judgment, sometimes in ways that go against their best interests. It doesn’t matter how smart you are or how well you understand the market, our brains often have a mind of their own — and can make us do things that hinder, instead of help, our investment growth.
Over the last several decades, the field of behavioural finance — the study of how our psychological influences impact our financial decisions — has exploded, with everyone wanting to know more about the powerful financial blind spots that might impact how people invest. If we can learn more about what affects the decisions we make, like why we feel compelled to sell when the market drops, we can make better investing moves.
While researchers have identified more than 100 blindspots that can impact our decision-making, there are four main ones every investor should know.
1. Confirmation Conundrum
When your existing beliefs trump reality
Imagine holding the belief that all people who wear red glasses are smarter than those who wear green glasses. Maybe you read that somewhere and it made sense, even though there’s plenty of evidence to suggest that the colour of someone’s glasses has no impact on their intelligence. You then find yourself at a party talking to someone who, lo and behold, is wearing red glasses. Now, whatever they say sounds smart — and true — to you. That’s confirmation bias: people tend to look for and favour information that confirms their existing beliefs. While this helps people make sense of life without having to study and examine everything, it also gives them tunnel vision, causing people to pick out information that aligns with what they already believe to be true. That can be trouble when it comes to our money. For instance, someone might be so enamoured with the CEO of a company that they fail to see that person’s mistakes. Sure, revenues are tanking, but that superstar executive will find a way to turn things around.
Having a solid investment plan doesn’t make you immune to confirmation bias either — in fact you could end up clinging to the plan against your better judgment. A 2018 study in the International Journal of Economics and Finance explains it this way: “People are inclined to be attached to their investment thesis and are unwilling to consider or accept evidence that they are wrong. Thus, they make speculative bets and hold onto them even as they show a downward trend.”
It’s possible to sidestep this, but it takes some mental work. First, think carefully about your money-related values and assumptions and acknowledge that these might be impacting your investment strategy. Then look for varied sources of information with ideas that may be different to your own. Be wary of social media: one study looked at investor message boards and found that, among over 500 online responses, many exhibited features of confirmation bias that led to greater overconfidence, more frequent trades and, ultimately, lower returns. Research all aspects of an investment, even the stuff you’d rather skim.
2. The Repeat Rut
When we assume that a success or failure will happen again.
If it worked once, then it’ll work again, right? That’s the crux of what’s called the availability heuristic, which is when people assume a success or failure in the past will repeat itself. You might stick to bonds because they did well last year, or maybe you’re avoiding an emerging market because you once got burned.
Other terms, such as recency bias, also relate, and refer to our tendency to use recent examples and situations to guide our behaviours, rather than long-term trends or verifiable data. This approach may be particularly flawed: According to a 2021 study, investors tend to remember their past performances inaccurately. We fondly recall better returns than we actually got and forget our losses.
To avoid the availability heuristic, you must stick to the data. Instead of choosing investment products based on last year’s performance or because it always seemed to work for your mom or dad, look to reliable metrics, such as price-to-earnings ratio, earnings growth and dividend yields, and always consider new information. It’s tough: If someone suggests trying a strategy that goes against your past experiences, it can feel very uncomfortable. Push through that feeling.
3. Livid about losses
We tend to get more worked up about losses than gains.
What gets you more worked up, the thought of losing 20% of your money or gaining 20%? According to science, the answer is almost always the former. People tend to get far more upset about losses than they get excited about gains. That leads to loss aversion, which is when people do all they can to avoid losses, often at the expense of growth.
Loss aversion behaviour can include staying in extremely conservative, guaranteed investments instead of slightly higher risk products that can offer better returns. If a company’s share price starts tanking because the business has soured (rather than a normal market downturn), someone might hold onto that stock for dear life, because they think it’s only a true loss once it’s sold. On the flipside, a security could start inching up in price, but because the investor is so worried that the share price could drop, they sell it right away and can miss out on long-term gains.
Remember, investments rise and fall, but over the long term history has shown equity markets tend to move higher. According to one study, dwelling too much on future predictions can exacerbate the issue. If this sounds like a problem, then consider sticking to the investing basics: diversify your investments so when one security falls another might rise, do your due diligence to be sure that what you’re buying aligns with your investment philosophy and consider being a bit more conservative with your short-term investments, even if you tend to embrace more risk for the longer-term ones. Another tip: Look at your portfolio’s performance over the longer term. The market may have fallen by 10% over the course of week, but if you examine the numbers over the last three-to-five years your savings will have likely far exceeded any recent dip. More on loss aversion here.
4. The Familiarity Trap
People tend to do what feels familiar
We humans are creatures of habit: We eat the same things for Sunday dinner, prefer to travel to the same locales every holiday and when it comes to investing, we stick to whatever investments and strategies feel familiar. The problem? We end up ignoring companies, approaches and other investment products with potentially better outcomes. Investments that fall outside our comfort zone feel too risky, uncomfortable and downright weird.
One prime example of the familiarity blind spot is what’s called home bias – people’s tendency to prefer owning companies located in their home country. Many Canadians, for instance, have a majority of their assets in domestic equities, even though the country accounts for a mere 3% of the world’s capital markets. Why? Because people tend to be more comfortable investing in sectors and locales they’re familiar with. TD Economics has also found that people in Alberta own more energy stocks than those in other provinces, while investors in Ontario hold more financials than most others.
While home bias is not necessarily a bad thing – Warren Buffett has often said to invest in what you know – you don’t want to base an entire strategy around what feels familiar, or you could end up too concentrated in one industry or area of the market.
As is often the case with overcoming blind spots, diversification is one potential way forward. If you want to add a new stock or fund type to your asset mix, then consider doing it gradually — add to what you already have and if you run into trouble then at least your other assets should balance out any losses. Once you see how a strategy or investment works, you may want to increase your exposure to it.
It’s hard to break these blinds spots overnight — it takes baby steps and a lot of hard work. But if you want to invest and grow your assets you might need to take a close look at what’s keeping you from realizing your full potential.
