You have probably heard the phrase ‘to be fearful when others are greedy and greedy when other are fearful’. These words of wisdom are attributed to Warren Buffett, the world’s greatest value investor of all times and refers to taking a contrarian approach when investing. 

However, acting differently from others is not easy, whereas following what others are doing is more accommodative by nature. Yet, by doing so investors may lose their ability to think and act logically when it comes to what is right for their investments. 

The theory of behavioural finance attempts to explain how investors process events and form their financial decisions. A true understanding of a series of intrinsic behavioural characteristics will ultimately allow us to predict market movements and possibly profit from them as well. Admittedly, humans do not always think logically because of a mixture of emotions, anxiety and feelings which lead us to act impulsively, impacting our self-control. 

This is what is known as the fight or flight factor which explains how our brain reacts when we perceive a harmful event or threat to survival. A case in point is the current situation which has brought huge disruptions to our daily routine without a clear indication of how and when it will end. As investors, we are also concerned about our investments and the possibility of potential loss. We inherently think negatively, which often causes us to overreact and possibly panic. In such situations, we often become defensive and take irrational decisions in order to avoid losing our wealth. Behavioural theory involves different decision-making mistakes and biases which we tend to experience.

This, in turn, will ultimately make us more logical in the decisions we take even when it comes to our investments. Self-deception may be defined as making ourselves believe that we know everything while we ignore important information that may eventually help us take a more informed decision. This occurs when we tend to do mental shortcuts in decision making, like an educated guess or decisions based on trial and error. It also happens when we change our behaviour and decisions when influenced by others.

We don’t want to be different, so we conform with the general opinion. Likewise, we take decisions based on our current emotional state, meaning our mood can sometimes put us off track from thinking rationally. Biases in behavioural finance occur when we feel overconfident and have an illusion of control. Overconfidence in investing means we believe we know everything which often leads us to view our investment decisions as less risky than they actually are.

When an investment turns out to be profitable, we triumph our skills, while poor performance is considered simply bad luck! This self-serving thought is based on what makes us look best. Furthermore, we have the tendency to believe that we possess special talent in predicting, in hindsight, what had happened.

This is known as confirmation bias, where we tend to pay close attention and even look for information that confirms our belief while ignoring anything that contradicts our biases. A typical example is when one hears a rumour about a company going through a rough patch and the investor considers selling that security he owns without double-checking the facts.

A good story makes us understand the world better. The narrative fallacy bias is the preference for a good story that disguises the facts, limiting our ability to evaluate information objectively. Investors automatically assume that good companies make good investments, mistakenly believing that two similar activities lead to the same outcomes when that is not always the case.

This is called representative bias. In framing biases, we sometimes take decisions based on the way we absorb information. Investors may react to a particular opportunity differently, depending on how it is presented to them. This generally occurs when we are used to a routine, therefore finding it difficult to break habits or going against what is known and safe to us by exploring new avenues.

Anchoring biases occur when we tend to agree with the original information forming an immediate opinion that may result in us neglecting to take informed financial decisions. Loss aversion is a common bias, where we as investors may not take rational decisions, as we are so fearful of a loss that we tend to focus on avoiding this rather than on producing gains.  We have a tendency to follow or mimic what others are doing, known as the herd’s influence, a bias driven by emotions or instincts that tend to alienate us from our own independent judgement.

The biases described above indicate the need to focus on the process rather than the outcome. Nonetheless, when it comes to decision-making, we implicitly take a ’reflexive’ approach, meaning our emotions take over, forcing us to take automatic decisions. In effect, it makes us more prone to deceptive biases, emotional and social influences.

Conversely, when we are more ‘reflective’ and therefore more logical and disciplined in our decision-making process, it protects us from frivolous mistakes. Ideally, we should plan and be disciplined and stick to that plan, despite what is going on around us. Only by vigorously practising some techniques, are we able to take decisions in a more rational manner and improve our chances of investment success. The current moves in financial markets provide a good example of the behavioral biases mentioned above. Thus, trusting in common preferences is what makes us human. But learning not to do that and instead, acting more logically is what will make us successful investors. 

Using the current situation as an example of logical thinking and by visualising a turnaround (and eventually it will), we can reclaim positivity and the feel-good factor once again. We would then look back to missed opportunities due to the fear of taking bold steps and dip into the market since the situation would have been outside our comfort zone.

One must ask what if the market does turn around? Would I feel convinced to invest now knowing that my investment portfolio will reap the benefits in a few months or a year’s time? I think this will definitely be the case when this is all over.

Disclaimer: Joseph Buhagiar is a financial advisor at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, views and opinions provided in this article are solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.