Traditional economic theory puts forward the assumption that all individual investors would behave and act rationally by considering all information available to them. This would be then reflected in the prices of assets and ultimately what makes market efficient.
But we know textbook theories don’t apply in real life and investors do not behave rationally all the time. This is particularly true when markets reach euphoric highs or plunge to scary lows. The adrenaline rush kicks-in, the mental circuits around the cerebrum start firing and finally the investors’ gut instincts are triggered to prompt them to make the crucial decision whether to buy or sell.
Following these mental cues or tendencies can be harmful especially when logic gets thrown out the window. Decisions that may appear rational are in fact detrimental. To avoid the worst impulses of an investor, it is crucial that one recognises them first and apply clear mental filters to invest with a clear head.
Here are 4 common behavioural biases that can lead investors astray and how one can overcome them.
1. Recency Bias
Symptom: If you find yourself reacting immediately to every breaking headline and being trigger happy with your investments, you may be succumbing to recency bias which is the tendency to overemphasise new information. In this current 24-hours news cycle with the prevalence of social media, the investment realm has become a global echo chamber constantly reverberating with news alerts.
Ongoing developments surrounding the coronavirus outbreak and the ensuing market correction is a more recent example. But if there is something more contagious than any viral outbreak is the spread of fear; and investors are a fearful bunch. Add to that a web of disinformation and fake news, you have a toxic concoction festering with fear and market angst.
If you look at past outbreaks like that of Severe Acute Respiratory Syndrome (SARS) in 2003, the incident didn’t create any long-term impact to asset classes and equity markets promptly recovered after the outbreak was contained.
Having a recency bias will also almost certainly lead you to buy when markets are peaking and selling at the bottom. Investors end up chasing markets and headlines to catch up with performance which is not the ideal formula to invest.