Key points
- Heuristics are mental shortcuts that humans use to make daily tasks easier
- But such cognitive biases can hurt our investments
- An investment firm has outlined 4 common mental biases and the solution for each
Your own brain could be sabotaging your ASX share portfolio.
Heuristics are mental shortcuts that humans use every day to get through all the tasks that we need to do.
But these cognitive biases can make us behave irrationally, which is the bane of investing.
Ophir Asset Management stated in a blog post that how an investor behaves often has a bigger impact on returns than their level of knowledge.
"This is more relevant than ever given the abundance of information that's out there nowadays prompting investment action, combined with a dramatic [increase] in the ease at which investors can trade."
The investment team stated that if investors can be more self-aware of the psychological traps that can lure even the professionals, it will help them make fewer mistakes.
"But they will also be better placed to exploit the mistakes of other investors, including picking up undervalued stocks, and gain a massive competitive edge in building their wealth."
Here are 4 common mental biases and the solution for each:
Loss aversion
This is the irrational tendency for humans to feel much more distressed at losing money than the level of joy gained from winning the same amount.
For example, if you buy $1,000 worth of a particular stock, many people feel a lot sadder when it goes down to $500 compared to the happiness they feel when it rises to $1,500.
According to Ophir, the biggest investment mistake borne out of loss aversion is the unwillingness to cut losers.
"Even if they do not see any prospect for a turnaround, they wait to 'get even' on the position before selling."
Conversely, loss aversion also causes investors to sell out too early when a stock rises.
The remedy to the loss aversion bias is to stay invested for the long term, according to the Ophir team.
"Day to day, share markets have only a slightly better than 50% chance of going up and a slightly less than 50% chance of going down," the blog post read.
"But over longer periods like a month or a year, the odds significantly fall below 50% that your share portfolio will have gone down."
So looking at your ASX share portfolio less regularly is the most practical action to take. That'll cause less temptation to sell a winner too early or sell a loser too late.
Mental accounting
This is the habit of putting money into separate mental buckets, to be treated and valued differently.
For example, if an investor buys $10,000 worth of shares and it makes a $5,000 gain, the person may take more risks with the $5,000 compared to the original outlay.
"But a dollar is a dollar is a dollar. That is to say, money is 'fungible' — it is all the same no matter where it came from or how you earned it," stated the Ophir team.
"Taking greater risk with the portion gained by treating it as 'house money' violates the fact that all money is interchangeable."
The best way to combat this bias is to concentrate on the total return for a portfolio.
Confirmation bias
This psychological effect results in accepting information that confirms already-held assumptions and rejecting data that doesn't.
"This one stems from the fact that it's easier to digest information that accords with how we already view the world," the Ophir team wrote.
"The cognitive load is much higher when we have to try and integrate new contradictory information into our worldview."
To overcome this bias, investors should seek out advice that contradicts their current beliefs.
"At Ophir, we actively ask how we could be wrong in our views and seek out people or broker analysts that hold differing views to ours," the blog stated.
"Someone having a differing view does not necessarily mean you are wrong, but it can help stress test your position to hopefully provide a more balanced view."
Overconfidence
A common trap for investors is to think that they are better than they are.
Even professionals, who devote all their working hours to company research and portfolio construction, have trouble consistently beating the market.
But a cognitive bias causes many amateurs to think that they can do it.
"Surveys routinely show that more than 80% of people think they are better than average for a whole list of things — including driving, intelligence, and even looks."
In stock investing, this means many people trade too often and underestimate risks. They buy expensive ASX shares and sell cheap stocks.
Similar to confirmation bias, plurality is the solution to this bias.
"At Ophir, we try to fight overconfidence by stress testing all our stock ideas in a team environment where everyone else acts as devil's advocate," the blog read.
"We also explicitly consider how the stock would perform in a GFC-style scenario."
