Investing is not easy. Otherwise everyone would do it and be rich already.
The fact is that optimal investing always requires completely rational decision making. Unfortunately, humans are terrible at being completely rational.
Emotions, even for the calmest individuals, take over subconsciously.
So imagine that. Not only is investing hard, you have to constantly fight yourself to make the right calls.
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You consistently lose against the index
This human tendency to act emotionally is seen in the statistics.
According to research firm Dalbar, the average investor consistently earns less-than-average returns.
"Dalbar found that for the 20 years ending December 31, 2019, the S&P 500 Index (SP: .INX) averaged 6.06%pa. The average equity fund investor earned a market return of only 4.25%pa," stated a BetaShares blog post.
Even during 2020, when we saw a spectacular stock market bounce-back after a COVID-19 correction, the average investor earned 17.3% versus the S&P 500's 18.4%.
And the gap was horrifying in the first half of 2021, when the average investor reaped 13.14% while the index went up by 15.25%.
So, as retail investors, how do we combat this?
The first step is to recognise how emotions compel us to make wrong decisions.
"While almost everyone is susceptible to the influence of emotional factors, it is important to raise these influences from the unconscious to the conscious," stated BetaShares.
"Educate yourself on the biases that investors are commonly prone to, and ask yourself whether your decisions are being influenced by them."
Here are 5 behavioural biases that BetaShares warned investors to watch for:
Cognitive dissonance
When new information disagrees with existing knowledge, it's emotionally jarring. To regain their comfort, people may form "obscure rationalisations".
"As a result, we may often focus on the positives of the selection we have already made and ignore the downsides implied by the new information," stated the BetaShare blog.
"From an investment perspective it means we may be overly focused on a stock or an ETF's upside whilst ignoring the risks."
The remedy to this bias is to treat information that challenges your existing beliefs with as much respect as views that agree with your ideas.
Confirmation bias
This is when an observation confirms our existing beliefs, thereby increasing our conviction, to the exclusion of other possibilities.
For example, if you have a preconceived idea that brown-haired people catch a cold more often than others, every time you see a brunette fall ill it reinforces the theory. This may happen even though all black-haired, red-haired and blonde acquaintances may not present themselves to you when they catch a cold.
BetaShares used the investment example of holding a belief that ASX shares are superior to overseas markets.
"Positive forecasts for the Australian market may be accepted without question, while information supporting strong performance of international equities may be discounted," the blog post read.
"This may help us justify being invested in only Australian equities with little diversification."
The moral here is to evaluate all information neutrally, regardless of whether it supports or refutes existing beliefs.
Illusion-of-control bias
This is the false belief of investors that they have influence over a situation that they can't possibly control.
The movement of a stock's price, for example.
"This can lead to investors being impatient and trading in and out of the market under the assumption they can control the investment outcomes," stated BetaShares.
"It can also lead to overconfidence and taking larger than usual risks."
Always remember the things about your investment that you can definitely control, like purchase price and exit price. Outside of that, there is not a lot that retail investors can influence.
Regret bias
This is when the fear of later regret paralyses decision making.
"Under the influence of this bias, investors start to anticipate and fear the regret that may come with incurring a loss or forfeiting a gain."
Regret bias makes investors "timid" and unwilling to try different opportunities.
"This may lead to missing out on new – but unfamiliar – investment opportunities such as emerging markets or new sectors, such as technology."
Perhaps the best way to combat this bias is to remember there can also be regret after not taking action.
Conservatism
Conservatism makes investors stick to their existing views while sacrificing important new information.
"If a recent stock or market outlook is poor and is at odds with a previous positive outlook on the economy or stock, there is a tendency to disregard the latest set of information," the BetaShares blog read.
"It means we may under react to fundamental information."
This bias can be overcome by treating later information with as much credibility as early impressions.
