One of the basic principles of classical economics is that people behave rationally and therefore maximise their economic potential.
More recently a field called behavioural economics has opened up, which recognises that people are not always rational and it applies psychological insights to explain economic decision making.
When given a ‘hot tip’ or confronted by a sudden drop in the value of an asset we are invested in, most of us will be tempted to act. This is entirely natural, but unless we have a clear insight into the underlying causes, it is rarely a sensible approach.
There are a whole series of behavioural biases which can influence decision making:
- Anchoring bias is using an arbitrary price level [.g. €100] as a trigger to buy and sell assets.
- Confirmation bias is focussing on information that supports our opinions while ignoring information that contradicts them
- Disposition effect bias is categorising investment as ‘winners’ or ‘losers’ and acting accordingly.
- Familiarity bias is the tendency to prefer investments you are familiar with such as well know companies or Irish Government bonds.
- Hindsight bias is attributing inevitability to an event after the fact when in reality it was unpredictable.
- Loss awareness bias is the tendency to avoid the pain of loss by avoiding decisions which may lead to a negative consequence.
- Self-attribution bias is attributing success to your own actions and/or failure to external factors.
- Trend-chasing bias is taking past performance alone as an indicator of future performance.
- Worry is allowing anxiety to affect your perception of risk.
Taking professional financial advice helps remove the temptation to react to sudden market fluctuations, ‘hot tips’ or short-term changes in asset values.
Investment professionals say ‘time in the market is more important than timing the market’. This means most people will do better by staying invested through ups and downs of the markets rather than trying to chase performance and ‘time’ their investment decisions based on short-term market movements.
Investment managers make trades only when there is reason to do so with a view to maximising returns, while minimising the chance of loss.