Behavioural investing: Why investors can be their own worst enemy

"The investor’s chief problem – and even his worst enemy – is likely to be himself.“

Benjamin Graham, Economist and Investor


Every investor will live through a downturn, a rally, and everything in between. How we respond to those movements can matter more to our long-term results than the movements themselves. In this month’s spotlight, we discuss some common behavioural biases and how they can affect an investor's decision making and long-term outcomes.

Behavioural finance experts point to three patterns that come up consistently.

The first is performance chasing: piling into whatever has done best recently, a habit driven by what is known as recency bias; essentially, the assumption that a recent trend will continue.

The second is giving too much weight to the latest headline rather than the bigger picture, a pattern known as availability bias. A single dramatic headline can dominate an investor's thinking for weeks. The story that's easiest to recall isn't always the one that matters most. 

The third is panic selling: pulling money out after a downturn, driven by what behavioural experts call loss aversion, where a loss tends to feel more painful than an equivalent gain feels good[1].

Decisions based on these behavioural biases can often feel rational. Each can appear to be the sensible action to take at the time. In practice, however, excessive trading driven by these instincts tends to lock in losses or reduce future returns for investors in the long run[2]. 

Recency bias

Recency bias (the tendency to place more weight and emphasis on recent data and trends) and herd mentality(the pull to feel safer sticking with everyone else rather than standing apart)have shaped market leadership many times before. Whatever theme is winning tends to draw in more and more investors, right up until it doesn’t. The theme changes each cycle; the underlying behaviour doesn’t. 

Chasing whatever's outperforming right now is a bit like switching to the lane that looks like it's moving faster in traffic, only to watch your old lane speed up the moment you've moved. Some of the areas that had delivered the strongest returns over the previous 12 months have also experienced some of the sharpest reversals, as investors have unwound positions built up during a period of exceptional momentum. Yet broader market indices, which span a much wider range of companies and sectors, have remained comparatively stable.

Investors who chase the latest winning theme can find themselves repeatedly changing lanes, buying into yesterday's success only to be caught when market leadership shifts. Maintaining a diversified portfolio with exposure to different sectors, regions and investment styles can help reduce the impact of these market rotations and provides a more reliable way of navigating markets over the long term.

Availability bias

The headlines can often be dominated by a single dominant story. A hot IPO, or a sudden rise in popularity for a company, sector or country, is often enough to cause investors to rapidly buy and sell based on information most frequently discussed, rather than a balanced assessment of all available evidence. The constant coverage of rapid growth and soaring prices can also create the impression that a theme is certain to keep out performing the broader market. 

As a result, investors may tend to allocate an excessive proportion of their portfolios to whatever's dominating the conversation, while overlooking risks such as valuations, increased competition, or the potential for slower growth.

Loss aversion

Irrational instincts are deeply human, and psychologists have been documenting them for decades. When values fall sharply, loss aversion can make the urge to do something feel overwhelming, even when doing nothing would serve us better in the long term. This is exactly why professional investment processes exist: to take the emotion and bias out of decision-making, rather than relying on willpower alone. 

One simple technique is to build in a “cooling-off” period before making significant investment decisions. [3]Giving yourself a day or two to reflect can help prevent temporary emotions from turning into permanent portfolio changes. It can also be useful to revisit the reasons you invested in the first place and ask whether anything has fundamentally changed about your long-term goals.

Panic selling is where this bias tends to cost investors the most. Consider an investor who steps out of the market during a period of uncertainty, intending to wait until things calm down before reinvesting. Markets often recover fast: seven of the global stock market’s ten best trading days over the past 20 years fell within just 15 days of its ten worst [4]. That makes it very hard to sit out the worst days without also missing the best ones.

Missing just a handful of the best days can have a significant impact, as the table below shows.