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RP: Hello there. Studies have repeatedly shown how active investors consistently underperform the market. Costs play a big part, and so does behaviour. For example, we often panic when markets start falling.
But investors are also irrational when deciding which stocks or asset classes to invest in and that’s often down to something called confirmation bias. Here’s Tim Richards, an expert in behavioural finance.
TR: Back in the day when I was roaming bulletin boards, it was very very striking there was a pattern of behaviour. People would invest in a share and if somebody else came along and told them how much they liked it and all the good things about it, they get massive support. As soon as somebody popped up and said - “Well actually, I don’t think this is such a good idea.” - the response was to attack the poster, it wasn’t to attack the idea.
We are habitually driven to look for confirmation of our ideas. In fact, we find it very very difficult, when we are presented with something, to think of ways of disconfirming it. The brain just doesn’t work that way. We are presented with a list of things, we only look at the list, we don’t try and think of all the other things that could possibly happen. There is lots and lots of assertion on confirmation bias, how people just comprehensively, consistently fail to look for the things that would disconfirm their idea.
RP: Closely related to confirmation bias is overconfidence. Many investors think they’re better at trading on the stock market than they actually are.
In a 1998, Terrance Odean, professor of finance at the University of California, Berkeley, published a study analysing the activity of 10,000 trading accounts in the US. Odean showed that investors habitually overestimated the profit potential of the stock trades they made. In reality, the profits they made typically didn’t even cover their transactions costs and, on average, the stocks investors bought underperformed the stocks they sold.
TR: There’s some evidence that we are hardwired to be overconfident. This evidence goes into some of the neurology of the way the brain works. It appears that in some circumstances, the brain is much much happier - will weight more heavily - information that is positive than information that is negative. So, over-optimism is a classic behavioural bias, tend to affect everybody. Perhaps, what we’re actually seeing is how the brain actually works.
RP: So, as an investor, you should avoid simply following your instincts. You should guard against ignoring information that contradicts your opinions.
You should also be aware of your limitations. Remember, the markets reflect the opinions of millions of people, including the professionals. It simply isn’t realistic for most of us to think that we have an edge over everyone else.
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