Three behavioural biases to watch out for during a crisis

Independent Pilots Financial Services is part of the Benchmark Capital Group, backed by FTSE 100 company Schroders. Our investment committee often draws upon Schroders vast resources. This piece is written by one of their investment writers.

Nick Kirrage walks us through the most common behavioural biases investors suffer from and how to overcome them.

At the best of times, investors are at risk of succumbing to certain behavioural biases that can cloud judgment and impair decision-making.

In highly stressful and unpredictable times like the Covid-19 crisis, there is a greater propensity for this to happen, and it can be highly detrimental to long-term goals.

InvestIQ is Schroders’ proprietary questionnaire platform that helps investors identify their investing personality and highlights the behavioural biases they are most likely to experience when investing. Since its launch in 2017, the test has been completed by more than 53,000 people across 16 countries.
Our latest data shows that the top three biases investors are likely to suffer from are ambiguity aversion, over-optimism and loss aversion. We spoke to Nick Kirrage, Co-Head of the Schroders Value team, for his views on these biases and tips to overcome them.

Ambiguity aversion

This is also referred to as uncertainty aversion, because it’s about preferring the known over the unknown; such investors tend to invest in what they believe to be safer and more predictable investments. The risk is that they opt for investments with lower returns instead of riskier investments which, while they have no certainty of what they will deliver, have potentially higher returns.

Nick Kirrage said:

“There are no certainties when it comes to fund management (or everyone would get rich!), only various possible outcomes and various probabilities these outcomes will happen.

“It’s extremely hard to take low risk and make big returns so we have to constantly remind ourselves that the more certain we are in our views, the less likely we are to make big returns for clients.

“A sweet spot exists where you have confidence (but not certainty) in your forecast for a company, but can still make good returns from the investment”.

Loss aversion

The second most common investor bias, loss aversion, means investors end up trying to avoid losses at all costs rather than logically considering the alternatives. The risk is that they miss out on good gains because the anticipated emotional consequences of loss are too much to bear.

Nick Kirrage said:

“Loss aversion is one of the most powerful human biases. There are no fail-safe ways to avoid it but my tip would be to force yourself to put numbers around your negative predictions: work out the implied probability the current market share price puts on a company going under.

“For example, in 2008/9 banks were under huge pressure and investors, including ourselves, were worried about their prospects. So we performed this exercise and the market seemed to believe there was an 80% chance a number of banks would go bust.

“This probability seemed way too high and allowed us to turn our focus away from our fear of loss and onto the idea that ‘if the market is already very confident any investor will lose money today, surely there’s a lot of money to be made if things are only marginally less bad than assumed?’”.

Optimism bias

The third bias, optimism bias, is the tendency to overestimate the likelihood of success compared to the likelihood of failure. This is only a bad thing if it leads to you ignoring key warning signs or miss the potential pitfalls of an investment because you’re being overly optimistic about its prospects. Used in the right way, the tendency to be optimistic can be a good thing.

Nick Kirrage said:

“This is a bias that we don’t look to avoid, but rather seek to redirect.

“Instead of being optimistic about companies that are already doing well and trade at expensive valuations, we try to redirect this optimism towards companies that are currently suffering and have low valuations. What if these companies can recover? What if their current ills are not permanent?

“These companies tend to have a combination of a low valuation and low expectations, which can be a rewarding place to invest. By using our natural optimism in a more contrarian way (being optimistic about less loved stocks) and less herd-like way (being optimistic about well-loved stocks) we can look to make better returns for clients”.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

This information is not an offer, solicitation or recommendation to adopt any investment strategy.