To meet his needs, today’s investor has global and unlimited access to multiple sources of information. The press, specialist sites, social networks, interpersonal relations, strategic advice and recommendations are all available. To the point where we have everything and the possibility of rapidly becoming specialists in numerous financial domains.

“Well-planned risk begins at home”

By having direct access to company figures, macro-economic trends and investment offers and solutions, the private investor has numerous means at his disposal to succeed in stock exchange investments. However, whilst he may have a good grasp of all his risks, he cannot control all of them, starting with the principle: himself.

The leading investors do not fall into this trap. In fact, Benjamin Graham has said that the investors’ main enemy is none other than himself. Warren Buffet was fond of saying that “the most important quality for an investor is temperament, not intellect”. This, to control the urges that can lead others to take misguided investment decisions.

Cognitive bias and its consequences

Investors are influenced by cognitive biases that overcome their ability to discern. These thought mechanisms have the unfortunate effect of reducing skill in investment, as they cause a deviation in perception and judgement.

Investors’ decisions are influenced by different biases: the mood of the moment, the capacity to master emotions, the propensity to want to minimise regrets or even fear of the unknown.

These are the elements that must be considered in analysing economic behaviour.

Do you know your bias?

If you see yourself in any of the trends listed below, think twice before investing. At least, seek good advice.

• • Why are you selling all your securities at a loss on the same day?
  • Why do you never buy securities again on which you lost money?
  • Why don’t you want to sell shares that have just fallen?
  • Why don’t you change anything in the portfolio that your grandmother left you?
  • Why do you take more risks after collecting unexpected gains?
  • Why do you keep your falling securities longer than your increasing securities?
  • Why do you have shares of the company that employs you?

Behaviour that is easily influenced

There are several thousand securities on the financial markets. As what is on offer is absolutely huge, it is impossible to know all the instruments available. So, it frequently happens that investors take the decision to invest in a security because “everyone is buying it”, whilst ignoring the underlying analysis concerning it. In this type of case, it often happens that the value of the security goes up, not because its fundamentals are improving but because it is driven by trend.

This mass phenomenon is characteristic of bubbles. Bitcoin and crypto currencies are good examples of this. The internet bubble observed more than twenty years ago is part of the same movement. Morality: to do as others do is irrational, as the investor blindly reproduces decisions that are the result of a mass effect.

Excessive confidence

The tendency that leads us to over-rate our intellectual faculties may be a source of disappointment on the stock exchange. This bias has been highlighted by psychological experiments that show that, in various areas, a significant majority of market movers consider that they have above-average ability. This type of bias makes the investor more “aggressive” on the markets and increases his risk-taking as well as his inclination to under-diversify or even deliberately to ignore contradictory information.

Excess of confidence encourages the investor to generate more transactions. He thinks he can be better than the others, and he is therefore going to buy and sell securities more rapidly. Behavioural finance studies have also shown that such investors tend to buy after increases in value and
to sell after falls in value. In other words: at the worst time. This is without considering that, if
the investor suffers from this bias, it is harder for him to see his mistakes.

The disposition effect

Our psychology is so made that we perceive our losses with greater intensity than our gains. As a result, an investor will take greater risks if he is in a loss situation. It is the old “casino” reflex which the sentence “I am going to win my money back” perfectly expresses. An investor with this disposition will therefore tend to sell too quickly positions that gain money and to keep for too long positions that are loss making. In the same way, risk aversion may lead an investor suffering from the “disposition effect” to sell a security at its lowest historical level instead of profiting from it by buying more of it.

Confirmation bias

Another frequently observed type of behaviour is the confirmation bias. Once he takes his decision, the investor manifests a strong tendency to dismiss any information that could make him change his mind. In fact, he will find any argument to dismiss from his mind any contradictory argument and to confirm his opinion. In the same way as a political debate followed on television, the television viewer with a committed position will not listen to the arguments of the opposing party. Our brain is wired in such a way that it develops tension where a type of behaviour contradicts his ideas or his beliefs. He will then seek to correct what he hears. By ignoring any contrary information in order to preserve a certain mental stability.

The confirmation bias encourages investors to ignore indications that do not support their strategy. They over-value the information that confirms their beliefs and under-estimate the importance of other information. This may also lead to excessive concentration on one security and to a lack of diversification.

The age of reason

The types of behavioural bias described above are unfortunately not the only ones. There are dozens of them that intervene in our decisions and make our investments vulnerable to uncontrolled risks. It is therefore essential to reduce them. Opting for a clearer and more precise investment process
may help. Also, the installation of barriers or predefined limits can militate against hasty and unsupported decisions. Because that is the whole challenge, and the investor must keep as far away as possible from anything that has to do with the emotions, closely or remotely. The science of investment prefers facts and data. For the very aim of avoiding bias.

In this respect, financial skill, research and analysis are clearly necessary to maximise the management of his portfolio. Controlling his emotions and applying a process-based structured approach are also the keys to success.

Delegating the management of his assets to professionals allows to substantially avoid all these biases. Finally, never forget the golden rule: long-term investment is the best way of reducing risk. It allows us to refrain from jumping on trendy securities when they are overbought or on the contrary from running away from the markets in a panic.