Bias can have a significant effect on our decision-making method when faced with investing in unit trusts
Here’s an effective analogy to put this statement into perspective: If you toss a coin 10 times and each time it lands on tails, what do you think the result of the 11th toss will be? There are two options:
- You may call tails again because you make the assumption that the trend will continue or;
- Choose heads if you feel that the trend will buck.
Heads or tails? Statistically, there is still a 50% chance that it will land on either heads or tails, but personal biases can determine the choice you make; we all interpret information differently. Our biases coupled with the consequent emotions may have a damaging effect when we apply the analogy to investments.
Consider a counter example; you have an opaque bag containing 50 green and 50 red marbles. If you remove 10 green marbles, what colour do you think the 11th marble will be? A rational answer would be red since the probability is higher (50 of the 90 remaining marbles are red.) Unlike the coin toss example, the removal of the 1st and 10th marble presents information that is relevant in guiding our choice.
Emotions may hamper investment success
Investment fluctuation (how much your investment value increases and decreases over time) can cause an investor to panic; this emotion may result in them switching or withdrawing the investment if they feel they’re losing value. This rapid decision has likely produced an error in judgement.
Common biases that everyone experiences are overconfidence; greed and fear. All of these can affect your choices and subsequently, the success of your investments. This is a common problem often addressed by Dan Thompson of Wise Money Tools.
Keep a level head
If you are feeling panic starting to set in, rather speak to a financial advisor or investment services company instead of making a hasty decision. The adage, ‘patience is a virtue’ is apt in this case. Remember that investment fluctuation is not a risk in itself; it exists on paper. The value loss of your investment only becomes a certainty if you withdraw the investment after it has lost value.
Don’t toss coins, choose marbles
The coin toss and marble examples illustrate the difference between impulsive decision making and rational assessment of the information presented to you.
By keeping a level head, evaluating the information and applying it where appropriate, you are more inclined to yield a better result than making a quick-fire decision based on biases.
So, is there a way that we can override biases? Potentially, yes. The key is to:
- Trust the investment philosophy and process that your investment manager follows.
- Have a comprehensive understanding of the unit trust in which you have invested. If you have invested in equity funds for example, it’s important to accept that market fluctuation may have a greater impact on your investment, compared to balanced funds.
- Know your financial objectives
- Have realistic expectations
- Let an independent financial adviser help you create an investment strategy that is tailored to your needs, risk tolerance and investment horizon
Keep these five points in mind when developing an investment strategy and remember to not let emotions cloud your judgement.