The human brain is hardwired to survive and will make split-second decisions based on millions of years of instinctual evolution.
But while these instincts may boost your chances of living in the wild, escaping predators and catching prey, they are often unhelpful or even irrational in a context that demands a long-term focus.
Investing is one such context, and in the financial world, cognitive biases are sometimes dubbed “investor biases”.
The evidence-based approach to investing aims to counter these investor biases. Looking at large data samples and historical trends, an evidence-based approach focuses on empirical research rather than emotional reactions, enhancing the likelihood of capturing long-term, steady returns.
Read on to discover four common cognitive biases countered by an evidence-based approach to investing.
1. Loss aversion
The theory of loss aversion posits that people generally feel the pain of losing something more than the pleasure of gaining something of equal value.
For example, if you were offered a coin toss in which you would win £20 if it landed on heads but lose £20 if it landed on tails, would you be willing to take that gamble?
Statistically speaking, you are unlikely to say yes, as most people are inherently more averse to losses than they are motivated by equivalent gains.
Research suggests that you would need the gain to be around double the loss to be willing to take the bet. So, you would need to win £40 if you won the toss, while your stake would remain at £20 if you lost it.
Loss aversion is a key concept in investing and is one of the main biases that an evidence-based approach aims to counter.
For example, the human propensity for loss aversion could cause you to exit the market during a dip to avoid further losses. This strategy ignores the evidence that the chances of your investments making real value gains increase over longer time horizons, and that market dips and volatility are not unusual.
The graph below shows the percentage of time you would have made losses in real terms over different time horizons.
Source: Schroders
As you can see, the longer the investment horizon, the lower your chances of making a loss.
So, an evidence-based approach that focuses on long-term investments and ignores short-term volatility mitigates the influence of loss aversion and increases your likelihood of yielding gains over longer horizons.
2. Overconfidence
In finance, overconfidence bias refers to a scenario in which you overestimate your knowledge, intuition, or predictive capabilities.
While it is the antithesis of loss aversion in many respects, overconfidence bias can result in equally poor performance.
If you’re an overconfident investor, you may think you can optimally time the market or that you have a greater ability than most to select strong-performing stocks. This could lead to excessive trading, increased costs, and a greater exposure to risk.
Overconfidence can also cause you to under-diversify and concentrate your portfolio, believing you are on to a winning strategy. It often leads to rash, short-term decisions with little risk assessment and management to ensure any losses are covered by gains in other areas.
An evidence-based approach counters overconfidence by avoiding its pitfalls. It entails understanding that timing the market is not as consistently effective as time in the market, and that portfolio diversification is integral to managing risk and capturing returns from wider opportunities.
3. Herd mentality
Herd mentality can occur in many walks of life. It refers to the reassurance and comfort you may find in a concept or mindset widely believed or adopted by others.
In the world of investing, herd mentality can break out when people see a rise in a particular stock, sector, or asset class and then all move to invest. As investors drive up prices, they can create speculative bubbles that only last a short time before bursting, with many investors losing out.
For example, this famously happened in recent years with GameStop, but it is a common occurrence.
The GameStop crash occurred after the company’s stock price surged, driven by retail investors from the Reddit community. Once the buying frenzy subsided and institutional investors regained control, the stock price plummeted, causing significant losses for many latecomers.
Without proper research or understanding of the risks associated with following the crowd formed by the latest noise, you expose yourself to the potential fallout of a market downturn.
An evidence-based approach ignores market noise and focuses on capturing long-term, steady returns in favour of short-term trends driven by herd mentality.
4. Confirmation bias
Confirmation bias refers to the tendency to favour information that confirms and corroborates your existing beliefs, rather than being open to an alternative.
When it comes to investing, confirmation bias can come in many forms.
For example, you may actively seek news, analysis, or opinions that align with your current portfolio or investment outlook, ignoring evidence that suggests otherwise. You may even be presented with conflicting information that you disregard or downplay to favour your previous choices.
Confirmation bias can lead you to make suboptimal decisions, such as continuing to invest in a particular market longer than you perhaps should. It can also result in portfolio concentration as you may overlook diversification in place of investments that reflect your strongly held beliefs.
An evidence-based approach to investing counters confirmation bias by emphasising objective analysis of all available information, not just selectively favouring data that supports your existing views.
By evaluating both positive and negative indicators, an evidence-based approach encourages more balanced decisions grounded in empirical evidence rather than biased interpretations.
Get in touch
Cognitive biases are, by their nature, challenging to overcome or even recognise. That’s why we employ an evidence-based approach to investing, helping our clients achieve their long-term goals and secure financial stability.
To find out more, get in touch.
Email us at hello@vwmwealth.com or call us on 0141 229 4004.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
