5 common investing biases and how to avoid them

A cognitive bias, or psychological bias is like a subconscious trick your brain plays on you that might cloud your judgement. When it comes to investing, there’s a unique set of cognitive biases that could prevent you from making rational decisions with your money.

Andy Nasr, the Chief Investment Officer at Scotia Wealth Management, is back on the Perspectives podcast to breakdown five common investing biases and how you can avoid them. 

Click here for the transcript.

1:30 — Before we start, Stephen has to get something important off his chest with Andy
2:03 — What is a psychological bias when it comes to investing?
3:30 — Investing bias #1: overconfidence
5:35 — Investing bias #2: regret aversion
11:34 — Investing bias #3: herding
12:37 — Investing bias #4: being overwhelmed by options
15:47 — Investing bias #5: the endowment effect
17:24 — The most important take away when it comes to looking at these biases

Transcript:

You might have heard of a at least a couple of these biases and even if you haven’t you’ve almost certainly experienced some of them firsthand. Confirmation bias is a classic example. That’s when you subconsciously cherry pick facts that confirm what you already believe. Or the spotlight effect. That’s when we assume people are paying way more attention to us then they actually are. And of course, there’s cognitive biases when it comes to investing, too. Little tricks your brain can play that might cloud your judgement and ultimately prevent you from say investing wisely. And they can be hard to avoid.

Andy Nasr: You got to be willing to look at things fundamentally as opposed to getting swayed by sentiment.

SM: That’s Andy Nasr, Chief Investment Officer at Scotia Wealth Management. And his role with clients can sometimes be part advisor, part therapist.  

AN: It's more like rationalizing the irrational [laughs]. That's part of the job. The irrational behaviour that people tend to exhibit because of those biases. It's trying to make sure that it is in the realm of the rational.

SM: Andy is our guest this episode and will to try and keep us firmly planted in that realm of the rational. He’ll break down five common cognitive biases when it comes to investing and how you can avoid them. I’m Stephen Meurice and this is Perspectives.

Andy, thanks so much for joining us again. It's always a pleasure to have you with us.

AN: Thanks for having me. Always a pleasure to be here.

SM: So, before we get into things here, I need to get something off my chest. I'm a little hurt this has never actually come up before, but I've been told that you have no social media presence, but your dog has Instagram. Is that actually true?

AN: No, no, no. I have a cat and it's got a TikTok account. Although I haven't posted anything to it yet, which tells you how much I care about social media. It’s a cat. Cat person.

SM: Oh, a cat. Okay. What's the cat's name?

AN: Teddy.

SM: Okay.

AN: The TikTok handle is meek meow. Although I don't think anybody's following it. I might have deactivated it [laughs].

SM: [laughs] Okay. We're going to talk today about biases when it comes to investing. And I think you and I, Andy, have actually spoken about this a little bit before in some of our previous discussions around how sometimes the markets seem to react in a way that doesn't seem entirely logical. But maybe we can start with a bit of a definition before we fully jump in. What is a psychological bias when it comes to investing?

AN: Well, it’s when investors make decisions based on their experience, personal beliefs, emotions. When we chatted about it in the past, I think I might have referred to it as the difference between fundamentals, you know, how things are supposed to work and sentiment, which is how people feel. That's a pretty good way to characterize it. When you think of traditional finance theory or markets that are supposed to be efficient. And investors are making all kinds of decisions based on what they're seeing other people do or what the news flow looks like. That can certainly affect their ability to achieve their objectives over long periods of time. And, more often than not, they end up making some pretty bad decisions.

SM: Right. So, are you sometimes playing the role of therapist with your clients?

AN: It's more like rationalizing the irrational [laughs]. That's part of the job. The irrational behaviour that people tend to exhibit because of those biases. It's trying to make sure that it is in the realm of the rational versus, you know, react.

SM: Right. Okay, so we have a list of common psychological biases when it comes to investing. I figure we can go through them one by one, and you can explain what they are and how to avoid them.

AN: Sure.

SM: So, this first one on our list sounds like a common one, overconfidence. 

AN: Yeah, I think there's a lot of cases and instances where investors feel like they know better or more than the market. And the market is an odd thing. It's made up of a whole bunch of people that have different objectives, different time horizons. But investors can get overconfident when, you know, they feel like they know a story or they know a company or an idea better than anybody else. And that can tend to lead to other biases, such as hanging on for things for too long, or just this view that, you may be able to ride out a bad story and that doesn't always end well.

SM: So, what's the antidote to overconfidence?

AN: It's really just having a balanced, rational view, recognizing that you may not have all the answers all the time. You see this as an example with a whole bunch of what people call cult stocks, and they gravitate toward these securities or companies because they believe that there's a theme or a fad that is just going to propel them into the future. And if those investments start to do well, it can result in overconfidence, people hanging on to things. Even though, you know, it works on the way up and it also works on the way down. So just a general reluctance to kind of give in to reality because you've got so much belief in whatever you’re invested in.

SM: Are professionals sometimes subject to overconfidence?

AN: You better believe they are.

SM: [laughs]

AN: Of course, they are. Retail investors make up a small part of the overall market. So, a lot of institutions that manage money on behalf of retail investors, but they tend to be the ones that push the capital around. And so as much as retail investors may believe in something, like think of the Reddit meme stocks that were all the rage a little while ago. As much as investors may believe something, it's typically the larger investors that can have more of an influence on how things are valued or growth expectations, etc. So, it absolutely creeps into the institutional realm.

SM: Okay, next one, regret aversion, and I'll tell you, Andy, I have a lot of regrets. So, this one is near and dear to me. What does regret aversion mean when it comes to investing?

AN: I got a lot of regrets, too [both laugh]. We should chat after this, share some stories. You know, at the bottom of this building when we were making our way up, there's a Winners. I'm going to give you an example. So, Winners is owned by TJX. For everybody listening, this does not constitute advice.

SM: [laughs]

AN: So, you look at that company and I think it's a pretty good example of loss aversion, especially in the last few years. So, regret aversion, loss aversion, same kind of thing. And the concept is really based on people being much more sensitive to losses, feeling that losses are much more painful than the gains that they might get. So, they sell first, especially if there's risk and uncertainty on the horizon, and then they hope to get back in later. But you look at Winners, the parent company TJX. And what you'll notice is in the last few years, the stock has done just remarkably well. Forget about 52-week-high, this thing's at a five year high. And if you just roll a little bit back to, let's call it the beginning of the health crisis, what you notice is the stock, once the health crisis ensued beginning of 2020, the things up 65 bucks, health crisis happens, it got cut in half. Why did it get cut in half? Well, naturally and understandably, broad swaths of the economy were shut down. People were really worried about when we'd get back to normal, if we’d get back to normal. But here's a pretty well-capitalized business. The value of the business arguably didn't decline by 50%, and yet everybody reacted the same way, not just to that stock, but to risky assets in general because they were worried. And so that's a good example of loss aversion. Now, on the other hand, if you see evidence of some other psychological biases when you start to see how well that stock has performed since then. I think you're going to ask me about herding or chasing trends, but that's another one where when investors start to demonstrate more risk inclination because they feel like things are going to get a lot better, they pile into something and they're willing to look through whatever short-term noise might exist. So, it works both ways. You look at that company as an example, and we are sitting here right now talking about these psychological biases because it's timely. We're on the precipice of recession. We're arguably in recession in some parts of the world. And people are getting real worried about where to put money to work. And yet the market, it's rebounded a little bit. It's come back up. And people are looking at some of these securities thinking, ‘Well, even if we have a recession and it only last 12 months, do I really care if a company misses out on a couple of quarters?’ And so, they start to be willing or there's more of an appetite to look through some of the issues. So, you're starting to see some of that, and it does work on both ends of the spectrum. But in the case of regret aversion, it's that it's a loss aversion. Which is much more painful for investors to endure than hanging on to Winners or riding out gains. So, they do often sell first and ask questions later. And it's tough to time the market that people feel a need to do it because there's much more sensitivity to losing money.

SM: So, I'm wondering whether the answer to this question is going to be the same for each one of the terms that we talk about. But what is the antidote to loss aversion or regret aversion?

AN: Look, the hardest part for investors during periods of extreme market volatility, it's trying to figure out how to create portfolios, right? How to allocate their capital so they achieve their long-term goals. What more often happens is they tend to look at things a little bit too short-term. So, they’ll get worried about recessions, which don't last all that long, or geopolitical events that can exert a significant influence on the economy and sentiment. All of those factors, and even if they're macroeconomic factors, people will feel it. You know, high interest rates, high prices, a negative wealth effect because house prices are down or markets are down. Those will creep into investors’ mindsets. And this is where, you know, having advice, having a plan can help keep you a little bit more grounded. If you've got a plan, it's a long-term plan and fluctuations in the market really shouldn't affect your ability to achieve those goals over a long-time horizon. It also allows you to do one thing, which is real important. If you do have a well-diversified portfolio and you start to see major asset classes or even risky assets, risky securities, decline in value. And I say risky, I mean, more volatile. Really gives you an opportunity to deploy capital tactically, take advantage of the volatility. But to do that, you can't be steeped in regret, you can't have overconfidence, and you have to have your feet grounded. And so that really amplifies the value of advice.

SM: The types of things you're saying you're talking about the long term and so on. But you must have some investors, they're not necessarily planning for retirement. They're looking for a windfall or practically gambling. Some people might say that that's one aspect of investing in the stock market will be looking for the quick wins. Do you see a lot of that or really is what you're focused on people who are thinking about the long term?

AN: I get that question a lot. People always ask, ‘Give me one stock or two. What would you buy if you could put all your money into something now?’ My answer is always the same. My answer is you're asking the wrong person. To use a baseball analogy, we're never going to hit a homerun. We want to get on base and win the game. So, when we talk about portfolios and high-quality securities, it's building a foundation. It doesn't mean that you can't take risk. It's just important to recognize what risk you're taking and what kind of return you can expect for the risks that you're taking. Because that's a real important concept, a risk-adjusted return. And so, when people look to make money quick, what they often end up doing is taking on a whole bunch of risk. And that can result in some of the stuff that we talked about, you know, losses and other issues that can affect their long-term outcomes.

SM: Right. Next up, and you already mentioned this one briefly, is herding. That’s HE R D I N G. I can kind of guess what that is based on the name, is that similar to what you were just talking about?

AN: Yeah, a good example of hurting would be the meme stocks or the Reddit stocks that were all the rage not too long ago. Cryptocurrencies, NFTs, right? Pictures of rocks with lasers coming out of their eyes. In addition to marijuana stocks, the list goes on and on and on. And when everybody feels like they got a bead on something, especially when your neighbours are benefiting from some of these, let's get quick rich investment ideas, well, there's going to be a natural tendency to want to get in on the action. That can create a lot of froth, it can create a lot of bubbles. But when the bubbles pop, things get pretty messy.

SM: Right.

AN: That's why, again, it goes back to you can do some of that stuff if you're comfortable losing the money that you're going to allocate to it. But you got to have a good foundation that at least sets you up for what you're looking forward to down the road.

SM: Right. You have to be willing and able to actually lose that money if it comes to that.

AN: Yeah.

SM: Alright, our next psychological bias is being overwhelmed by options. 

AN: There's so many options.

SM: There are a lot.

AN: You know, I used to be a portfolio manager in another life. And when you're a global equity portfolio manager, there are literally tens of thousands of companies that you can choose from all over the world. You think of market capitalization, geographical location across industries and sectors. It's a lot to pick from. Imagine a retail investor sitting there thinking, ‘What am I going to buy and how much do I own and how do I create a portfolio to optimize return and risk and balance those things out?’ It's tough to do. And when you think of all of the variables that can affect returns, not only do you have the micro risk, meaning how’s the company going to do, how's the management team going to helm the company? How are they going to navigate the turbulence in an economy? Then you deal with currencies and regulations and all kinds of innovation and digital disruption. It's real tough to find high-quality companies that you're going to be able to hang on to for a long period of time, which is why you often see people making changes to portfolios because the global economy is changing at a rapid rate. It's deeply integrated, but it's also digitizing at a rapid rate. So, it's the construction of the portfolio that's very, very difficult. And there's no question there's a lot of choice. But we'd argue the choice becomes a lot more narrow if you're focused on building that robust, durable type solution, that'll help you achieve your goals. There's a lot that you can weed out by just making sure that you're aware of the risk that you may be taking when you're thinking of investing.

SM: Right. Even when it comes to mutual funds which bundle together companies under one sort of investment vehicle, there are still unending number of choices to choose from, even when it comes to that. But is that a way of simplifying things?

AN: Absolutely. A mutual fund or an ETF, it's a good way of outsourcing some of the stuff. And whether it's passively or actively managed, those are good options for people. If you're in an actively managed mutual fund, you're hoping that the portfolio manager or the institution managing that capital makes those decisions for you. And we've got some great asset management partners that have demonstrated a phenomenal track record and ability to do that. And if you’re passive, then you're effectively owning an index, which is a proxy for how publicly listed securities in any region will perform. Less security specific risk, but just a well-diversified basket of socks. It's not always well diversified, and I think you might be asking me about some other kinds of biases that may kind of pop up here. And one of them is familiarity bias, which is investors tend to gravitate toward things that they're most familiar with or are accustomed to. And one great example of that is home country bias. There are a lot of investors in Canada that own too much Canada not recognizing that Canada is a small part of the global economy and global market capitalization. The more that we talk about it, the more you see these biases pop up in almost  every part of the conversation.

SM: Right. Well, we will nonetheless end with just one more. And maybe that is somewhat related also to what you were just talking about, the endowment effect. What's that?

AN: That's when people overvalue the things they own just because they own them. Or they tend to place a greater value on things that they own or are familiar with. So, it's related to that familiarity bias. And there's examples of that. You see investors very often overvalue companies just because they think, ‘Well, it’s a great domestic business and it's in a monopoly or an oligopoly.’ Even though there may be businesses that do the same thing in other parts of the world that are much cheaper because maybe there's more of them that exist. So that endowment effect, it can be pretty dangerous because again, you tend to not end up making the most optimal decisions when it comes to risk-adjusted return and in portfolios. That applies to funds too, the same kind of concept.

SM: So that sort of ties back again into that loss aversion bias, because you just want to stay with what you have and you’re not willing to look further afield for something that you might not know as well?

AN: Yeah, I mean it could be that and down the road it could introduce more risk. Because if you're getting comfort with the endowment effect or the familiarity, then the issue is that you may be overlooking some problems that are bubbling up, but maybe that you're willing to overlook because you're just more comfortable.

SM: All right. Any other psychological biases that we should be looking out for in our investing or in our personal lives? Because I'm always looking for advice on that.

AN: Yeah, we'll chat after. [Both laugh] Look, there's lots that we can go through when it comes to behavioural finance. I think the most important takeaway for people is during periods of extreme market volatility, it's the opportunity. We've talked about this, but when you start to see asset class performance diverge and it didn't diverge recently, most everything has gone in the same direction, which is down. But when you start to see some divergence and you start to see those opportunities pop up, you got to be willing to take a little bit more risk. You got to be willing to look at things fundamentally as opposed to getting swayed by sentiment. And those are probably the most important takeaways. And that's where advice can help. That's where dealing with our great wealth partners can help as well.

SM: I think we will leave it there. Andy, thank you so much for joining us, always a pleasure to have you on the show.

AN: Always a pleasure to be here.

SM: I've been speaking with Andy Nasr, Chief Investment Officer at Scotia Wealth Management. The Perspectives Podcast is made by me, Stephen Meurice, Armina Ligaya and our producer Andrew Norton who doesn’t have a cat or TikTok, let alone a cat with TikTok.