We humans are not the rational calculating machines financial theory often assumes. In practice our innate biases cause us time and again to make investing mistakes.
For example, when we make an investment we tend to connect its apparent value to the purchase price. This ‘anchoring’ often leads investors to sell assets too quickly when their prices rise. Similarly the related ‘sunk cost fallacy’ causes us to hold poor investments for too long; if the asset’s price falls below our purchase price we become reluctant to crystallise our loss, even if the new price is the right one. The ‘confirmation bias’ and the ‘endowment effect’ likewise impair both our thinking and investing. The endowment effect causes us to overestimate our assets’ value compared to those we don’t own, while the ‘confirmation bias’ makes us seek out information that supports our previous decisions. Consequently investors often pass up new investment opportunities even when they are objectively better than their current ones.
Perhaps the most powerful behaviour is ‘herding’. Contrary to mainstream financial theory we do not make decisions as individuals; instead we form our opinions in groups. In fact, we find it very uncomfortable holding views that differ from consensus opinions. Such behaviour is partly responsible for some of the markets’ wilder gyrations.
At Equitile we acknowledge such biases and use clear guidelines in constructing your portfolios in order to help overcome, and even exploit, these in-built human tendencies.