Trick or treat? Turn your brain tricks into better investing moves

Why do some people make money, while others lose money on the same stock? 

There are many factors that separate the winners and losers in the investment world, but the most important quality that distinguishes good investors from the rest, according to Warren Buffett, is temperament.

We may be inclined to think that we are rational beings, who make rational investment decisions, but research has proven that our cognitive biases often interfere with our judgement.

Recognising and understanding these biases is the first step to cultivating investment discipline, which is crucial for building an effective, long-term investment portfolio. 

Read on to learn more about the five common investment psychological biases, and the ways to overcome them.

Loss aversion: Are you sabotaging your own gains?

Loss aversion is when people's fear and anxiety about losses far outweigh the joy from equivalent gains. 

Simply put, the pain you feel from losing $100 is much greater than the happiness you feel from gaining $100. 

While it is normal to fear losing money, allowing it to be the main driver of your investment decisions (which by the way, also includes choosing not to invest) can lead to erroneous decision-making, such as

• Refusing to cut losses of a losing asset
• Panic selling
• Taking profits too early
• Hesitating at highs

Loss aversion not only leads investors to make fear-driven decisions in the face of short-term market changes, but also affects how they handle their assets. 

How to fear less, and start investing better

If you think fear has gotten in the way of your investment goals on more than a few occasions, you can consider using a dollar-cost averaging strategy. This can be done by setting up automated transfers to invest a fixed amount regularly.

Additionally, maintain an investment plan that records your justifications for each investment. This plan will serve as a reminder during volatile times, helping you stay focused and avoid panic selling.

Depending on your risk tolerance and investment objectives, If you prefer a hands-off approach that doesn’t compel you to check your portfolio performance all too often, learn more about passive investing, and the Endowus Passive Index Collection.

Recency bias: Did you forget something? 

Recency bias refers to people’s tendency to give more weight to recent events and information when forming opinions or making decisions.

In investing, recency bias can cause investors to overreact to short-term market movements, potentially leading to poor investment decisions such as buying high during a market rally.

Recency bias creates blind spots where investors fail to see the bigger picture, leading to irrational behaviour that ignores fundamentals and macroeconomic factors.

In 2015, the Shanghai market rallied to nearly double in value after a government communication campaign was announced to encourage citizens to invest in the market. The bubble burst shortly after.

Fast forward to today, investors scrambled to the China stock market after the government announced a stimulus package aimed at boosting economic growth and revitalising the stock markets in September 2024. This rally is unsettlingly reminiscent of the bull run in 2015, yet it seems that some lessons have been forgotten with time.

Recap history lessons every now and then

As humans, it’s only normal to forget. To overcome recency bias, sometimes it’s good to return to investing fundamentals that have stood the test of time to remind ourselves of our goals and strategies. 

Especially at the speed at which finance-related content is produced online today, it’s important not to get too consumed by every latest thing that the internet hypes up.

Home bias: Is home an illusion of safety?

Home bias is the occurrence when investors overwhelmingly prefer to invest in their domestic markets.

This bias stems from a sense of familiarity and perceived lower risk associated with local investments. 

As the saying goes, don't keep all of your eggs in one basket. Although we witnessed a robust rebound of the Hang Seng Index in late September, home is probably not the best, nor safest place for entire portfolios if you consider that overconcentration on Hong Kong / China stocks could mean several things: 

1. Missing out on exposure to global companies with strong fundamentals and growth
2. Higher exposure to country-specific risks, such as China’s economic dependence on policy stimulus and implementation

Going places with your investment portfolio

To invest better, investors should look towards meaningful diversification that reduces the impact of poor performance in any single country or sector, minimising the overall risk of the portfolio. This portfolio should ideally encompass a variety of regions, industries, and asset classes. 

Diversification is not just about capturing global opportunities. One is likely to sleep better at night knowing that the value of your portfolio is not going to take a huge plunge just from a single event alone.

Self-attribution bias: Are you in an ego trap?

Self-attribution bias describes people’s tendency to attribute success to their own abilities and decisions while blaming external factors or bad luck for failures. 

When investments fail, investors with self-attribution bias may blame market volatility, policies, or other external factors rather than their own decision-making errors, which may have stemmed from poor research or greed.

Self-attribution bias can lead to overconfidence and excessive risk-taking behaviours, obscuring individuals' ability to objectively evaluate their investment decisions.

Seek a second opinion (and a fair one)

Investors should consider consulting a financial advisor to seek an objective, well-informed second opinion. Having someone who isn't afraid to disagree with you provides an invaluable outsider’s perspective, helping to reveal biases that you might not notice on your own.

As always, staying informed about market dynamics, behavioural finance, and investment principles will help you stay grounded with the facts: the market’s winners tend to be the ones who are able to separate their egos and emotions from their investments.

Overreaction and overanalysis 

Overreaction and overanalysis refer to paying excessive attention to the markets and portfolios. 

We believe that investors should conduct regular financial reviews to assess if their current financial situations continue to align with their goals, but overdoing it can definitely backfire. 

Overreacting to the market can lead to emotional decisions, such as panic selling during market downturns or chasing after the latest hyped stocks. Frequent trading also increases transaction costs, further eroding investment returns.

Would you rather be a short-term or long-term winner?

Research has shown that investors who stay invested in the long run – as opposed to active traders – are more likely to generate better investment returns. 

To avoid the pitfalls of overreaction and overanalysis, investors should develop an investment plan based on long-term goals and personal risk tolerance, then more importantly, stick to it. 

Using passive investment strategies such as index funds, or outsourcing decisions to active funds with sound investment processes, can help investors reduce their focus on market fluctuations and stay more focused on achieving their long-term financial goals.

TLDR: How can you invest better?

1. Take a close look at time-tested investing fundamentals, not yesterday's stock indices.
2. Definite your goals and time horizon for each of them
3. Understand your investing temperament 
4. Create an investment plan that matches your goals, with a strong fortress built on a keen understanding of how you would react to market events
5. Stick to your plan

As investors, being able to withstand our cognitive and emotional impulses is no easy task. At Endowus, we believe that staying invested in the long run gives our clients the best chance to meet their investment goals. That's why we set out to simplify investing with tech-driven automation, and above all, straightforward portfolios with no hidden fees designed for every investor’s needs and risk tolerance in mind.

Our Flagship Portfolios are constructed and discretionary managed by the Endowus investment office to provide exposure to top-in-class funds managed by trusted fund managers including BlackRock, Amundi, and PIMCO.

Take just a few minutes to create your Endowus account and find a portfolio that best matches your needs.

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*Source: Vanguard, IMF's Investment Survey, Barclays, TR Datastream, and Eastspring Investment.

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