The psychology of investing: five big traps investors need to avoid

The last time I sat down to sort out my tax affairs for my accountant I was shocked at how often I'd traded shares over the past two years.

I'm still not sure why I was such an active trader but after reading a paper on investor bias from Russell Investments I think I may have been guilty of over-confidence.

This is one example of behavioural biases by investors that can impact their portfolios. People tend to overestimate or exaggerate their ability to successfully perform tasks, says the paper, and this can lead them to trade too often.

The paper, "How to Avoid Common Behavioural Biases and their Detrimental Impact on Investor Portfolios," also identifies "herding", which can result in people buying high and selling low; "familiarity", which leads to a home country bias in selecting investments; and "mental accounting", which can result in naive or inadequate diversification.

"Not being confident enough can also be a problem with investing," says Simon Russell, founder and director of Behavioural Finance Australia (BFA). You don't want to be so under-confident that you're only in cash and your money is going backwards.

Over-confidence

Over-confidence means you are less likely to diversify widely, says Russell.

"For example, you know the three best shares so why invest in anything else?"

"Diversification is the first rule of investing," says Scott Fletcher, client portfolio manager at Russell Investments, the publisher of the investor bias paper.

BFA's Simon Russell agrees that over-confidence also leads to frequent trading, which also has cost (trading fees) and capital gains implications - a lesson I have just learnt!

It also makes investors less likely to listen to third-party advisers or use other experts, he says. Filtering the noise from information overload is a key problem for investors, says Russell, but distracting noise is not usually around tax and capital gains implications.

Russell recommends investors look for supports, such as little barriers. For example, don't memorise your trading pin - just having to look it up makes you pause, he says, noting studies show that when you have to click through twice to reach a website rather than once, you are less likely to do it.

Also try to have someone who keeps you accountable, such as a spouse or a financial adviser; ideally a person who understands your processes.

Setting up a practice portfolio can also be a good way to test your processes. "If you're tempted to take your money out of a well-performing industry super fund and set up a self-managed fund, then set up a dummy portfolio for a couple of years - you might change your mind," says Russell.

Familiarity and mental accounting

Be aware of "familiarity", which encourages investors to invest locally, and "mental accounting," which can lead to naive diversification, when setting up your portfolio, says Fletcher.

Home bias means that 75% of Australian retail investors hold only domestic shares, despite Australia making up less than 3% of global market capitalisation, says the Russell Investments paper.

"Our global analysis shows that regardless of which home country the investor resides in, this phenomenon is shared across most countries." This exposes investors to significant country-specific risk.

Naive diversification can occur due to our hard-wired brains looking for simplification and generalisation.

This leads to a tendency to separate money into separate accounts and overlook the aggregate investment strategy. "This can lead to unintended concentrated risks in portfolios and, at worse, poorly diversified portfolios," says the paper.

Herding

"Contrary to the key of successful investing - buying low and selling high - many investors end up doing the opposite," says the paper. A herding bias, which makes us want to follow the crowd, can trigger this. Greed, where investors strive to extract every dollar of a position before selling out, may also be responsible for buying high and selling low.

"Some investors may sell at low prices as the market is falling to avoid more losses despite the investment being a sound one and helpful to achieve their long-term objectives. They may also miss out on true buying opportunities for fear of negative market sentiment continuing the downward trend."

Anchoring

Scott Phillips, general manager of financial adviser Motley Fool, says looking at past history can be a distraction. He labels it an "anchoring" bias. It leads to attitudes like "not selling because the price is down" or "surely you can't go broke taking a profit".

"Stop looking at past history, assume it hasn't happened," he says.

Fletcher agrees. "It's dangerous for investors to look in the rear-view mirror, trying to pick winners based on the last couple of years." The average investor's inclination to chase past performance has cost them 1.8% a year in the 34 years from 1984 to 2017 based on global analysis by Russell Investments.

One way to avoid anchoring is to not record your cost base in your list of shares, so you can't readily see how much you have made or lost on a particular stock.

Look at the company rather than the stock. You want to make a decision if a particular price is good based on the future. Ask if the company is becoming relevant to more people.

Appeal to authority

Another investor bias is appeal to authority - "something well known must be good" - which leads to investors favouring blue chips, says Phillips.

Separate the popular and well known from the successful by applying the same processes as you do to avoid anchoring bias.

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