A beginner’s guide to behavioural investing

Our mind is an incredibly complex machine capable of processing volumes of visual and audio information in seconds. It is this ability which allowed our ancestors to evade potential life threatening situations while on hunting expeditions. However, evolution has not only enabled us to make quick judgements and determine risks in rapid time but also, calculate, speculate and think critically. This dichotomy of thought is the premise of Daniel Kahneman’s book “Thinking fast and slow”, a powerful testament to diversity within human cognition, which reveals that we are all susceptible to cognitive dissonance and behavioural bias.

Kahneman, a renowned psychologist and Nobel laureate, categorises these two thought processes as ‘system 1’ and ‘system 2’. Where system 1 is the quick approach and system 2 is the slow methodical approach. As investors and indeed as rational beings, we need to be aware of these two competing thought systems in order to prevent system 1 from dominating our decision process. The three examples outlined below are common behavioural biases which may lead to disastrous investing;

1. Confirmation bias

We are perhaps all guilty committing this bias at some point in our lives. This is simply where we have a preconceived notion or idea and try to find information that confirms it. We essentially seek out facts which support our preconceived idea instead of gathering and examining data first and then forming a rational decision based on the evidence.  Investors beware! If you believe a stock is going to appreciate in value, pause for a second and ask yourself what are you basing your decision on? Is it hope, gut instinct or do you simply like the cut of the companies jib? Take a step back and employ system 2 and try to be as objective as possible, take in all appropriate information and finally make an informed decision.

1. Optimism

Optimists are fun people to hang around. They are the creators and innovators in our society. Google, Apple and other similar tech start-ups were all created by people with a positive outlook on life. A world full of pessimists would be dreary and nothing would get done out of a sense of futility. But why is optimism bad for investors? Well when it comes to investing we may tend to exaggerate our forecasting ability.  A couple of lucky stock picks and suddenly we consider ourselves experts. Soon we become so confident that we take more risk, use higher leverage and ignore the fundamentals. There will eventually come a day when you will pay a hefty price for your optimism, the merger you expected to take place fell through, profits dropped for the second year in a row despite your anticipated increase. So be mindful and treat any optimism with a degree of caution.

1. Availability bias

Which form of transport is safer, cycling or flying? The answer is of course flying. Statistically speaking you are far more likely to die whilst cycling than flying, yet many people would much rather hop on a bike than board a plane. This is down to the availability bias. People tend to recall dramatic events such as plane crashes and terrorist bombings far easier than non dramatic events. This is partly due to disproportionate and biased media exposure. Therefore in many instances we overestimate the likelihood of rare events occurring and underestimate the likelihood of common events occurring. Keep this in mind when investing.

So next time you find yourself investing using system 1, STOP, put it in a straight jacket and beat it into submission using the slow and methodical system 2. It may not be as fast or as sexy but it is smarter and will save you from embarrassing losses.

Keep an eye out for more behavioural biases and investment faux pas.

Written by Brian O’Toole