As an Australian financial adviser, I’ve observed that many investors struggle with decision-making that often contradicts their best interests. The root cause of this phenomenon lies in our evolutionary history. Let’s explore how our natural instincts can work against us in the modern financial landscape and discuss strategies to overcome these challenges.

The Evolutionary Mismatch

Our ancestors evolved in an environment where following the group and avoiding risks were crucial survival strategies. However, these same instincts that kept our forebears alive can lead us astray in today’s complex financial world.
As Devina Mehra, founder and chairperson of First Global, aptly puts it: “Evolution is frankly not interested in our portfolio or investments. Its only focus is on our survival and procreation”[5].

Common Cognitive Biases in Investing

Understanding and recognising our cognitive biases is crucial for making more informed investment decisions. Here are some of the most prevalent biases affecting investors:

Loss Aversion

Loss aversion occurs when investors are more concerned about losses than equivalent gains. Mehra explains: “In the markets, it means that a [$1] loss will make us far more unhappy than the happiness we may find in a [$1] profit”[5].

Herd Mentality

The herd mentality compels individuals to follow the actions of a larger group. In investing, this can contribute to asset bubbles or market crashes through panic buying and selling.

Overconfidence Bias

Overconfidence bias leads investors to overestimate their knowledge and abilities, often resulting in excessive risk-taking or under-diversification of portfolios.

The Performance Gap: A Real-World Consequence

The impact of these biases is evident in the performance gap observed in investor behaviour. Research from Morningstar’s ‘Mind the Gap 2024’ report reveals:

  • Fund investors earned a 6.3% per year dollar-weighted return over the 10 years until December 31, 2023
  • Their fund holdings earned about 7.3% per year
  • This 1.1% annual return gap is due to mistimed purchases and sales

This performance gap, compounded over time, can significantly impact an investor’s long-term wealth.

Strategies to Overcome Evolutionary Biases

To outperform the market, we must learn to invest differently from the crowd. As Warren Buffett famously advised: “Be fearful when others are greedy and greedy only when others are fearful”[4].
Here are some strategies to help overcome your evolutionary biases:

  1. Embrace Volatility: Use market fluctuations as opportunities rather than threats. Consider price dips as potential buying opportunities and reassess holdings when they reach your estimate of fair value.
  2. Focus on Fundamentals: While it’s important to be aware of macroeconomic factors, concentrate on understanding the fundamentals of the companies you’re investing in.
  3. Develop Deep Knowledge: Study financial statements, understand earnings and profitability, and assess competitive advantages. This knowledge will help you make more informed decisions.
  4. Implement a Systematic Approach: Consider adopting a rules-based investment strategy to remove emotional decision-making from the process.

As Mehra suggests: “If you want to buy stocks with specific characteristics, put that as a system and then actually buy all the stocks that meet those criteria”[5].

The Role of Professional Advice

While understanding these biases is crucial, implementing strategies to overcome them can be challenging. This is where professional financial advice can be valuable. A qualified financial adviser can help you:

  • Develop a personalised investment strategy aligned with your goals and risk tolerance
  • Provide objective analysis and recommendations
  • Help you stay disciplined during market volatility

As John R. Nofsinger notes in “The Psychology of Investing”: “A common adage on Wall Street is that the markets are motivated by two emotions: fear and greed. Indeed, this book suggests that investors are affected by these emotions. However, acting on these emotions is rarely the wise move. The decision that benefits investors over the long term is usually made in the absence of strong emotions”[1].

Conclusion

While our evolutionary instincts may not have equipped us to be natural investors, by recognising these biases and implementing strategies to overcome them, we can work towards becoming more successful in the financial markets. Remember, investing differently often means embracing discomfort. By doing so, you may position yourself to achieve superior long-term results. As always, it’s crucial to consider your personal financial situation, goals, and risk tolerance before making any investment decisions. As Peter Lynch wisely stated, “Know what you own, and know why you own it”[4]. This simple yet profound advice encapsulates the essence of informed and rational investing, helping us to overcome our inherent biases and make more sound financial decisions.

Citations:
[1] https://www.goodreads.com/work/quotes/1311965-the-psychology-of-investing
[2] https://www.nber.org/system/files/working_papers/w27745/revisions/w27745.rev0.pdf
[3] https://www.magellangroup.com.au/insights/decoding-cognitive-biases-what-every-investor-needs-to-be-aware-of/
[4] https://www.investopedia.com/financial-edge/0511/the-top-17-investing-quotes-of-all-time.aspx
[5] https://www.morningstar.in/posts/76606/biases-are-a-part-of-investing-but-you-can-beat-them.aspx