When Hungarian physician Ignaz Semmelweis made a discovery that would go on to save billions of lives, you can understand why he thought the medical profession would embrace it. As it turns out, it didn’t.
Back in 1847, Ignaz realised that the death of new mothers fell ten-fold when doctors disinfected their hands before moving from one patient to another. At the time, doctors would carry out an operation and then move on to the next without even washing their hands, and in some cases, would conduct operations after carrying out an autopsy.
Yet doctors rejected Ignaz’s findings, instead doggedly sticking to the norm of performing operations and delivering children without washing (let alone disinfecting) their hands first. It took 14 years for doctors and surgeons to eventually accept Ignaz’s findings.
Today, the reaction of the doctors is referred to as the “Semmelweis reflex”, which describes people’s bias towards rejecting new evidence when it contradicts their established habits or beliefs. It won’t surprise you to learn that this bias can also be seen in the world of finance, such as when investors reject evidence that a company or sector no longer offers the same level of growth potential it once did.
As humans we all have the potential to fall foul of the Semmelweis reflex, and many other biases that may result in poorer investment decisions. Discover five more you might need to be aware of.
1. Loss aversion
This bias refers to some people’s tendency to prefer avoiding losses at all costs, despite the possibility of potential gains. It’s usually because the individual feels more pain when they make a loss than the pleasure they feel when a gain is made.
The issue with loss aversion is that it could drive you to make a decision you later regret, which could include deciding not to invest or selling investments during a downturn. As an investor, short-term downturns should always be expected, and when it happens, it’s often best to keep calm and wait for the markets to bounce back, which they have tended to do in the past.
According to research by Schroders, between the start of 1952 and the end of May 2022, UK equities returned 11.7% a year on average despite the many downturns along the way. Cash returned 6% a year.
2. The “bandwagon effect”
The bandwagon effect is also known as herd mentality or following the crowd. If you invest in a company or sector because other people are doing it, it’s likely to be because of the bandwagon effect.
It is important to remember that successful investors tend not to worry about what other people are doing. They typically create a long-term plan that’s in line with their goals and stick to it. That’s not to say changes are never made to it, but when they are it’s not a reaction to other investors’ behaviour.
3. Confirmation bias
Confirmation bias occurs when people make decisions based on pre-established assumptions built on emotion rather than fact. This means that decisions may be made on inaccurate information.
An example of confirmation bias could be the newspapers that people choose to read, as they’re typically in line with their political beliefs. With finance, confirmation bias may mean you become wedded to the idea that a specific sector or company will perform particularly well or poorly – even when evidence suggests otherwise.
As a result, you could end up with a portfolio that isn’t sufficiently diversified, or you might hold on to shares in companies that are underperforming.
4. Familiarity bias
This bias might mean you tend to invest in a region or sector because you know and understand it. As a result, you may not diversify into companies or regions that might offer greater growth potential because you’re less familiar and less comfortable with them.
If you don’t diversify because of familiarity bias, you may be exposing your money to greater levels of risk than needed. So for example, if there is an unexpected fall in a particular sector or region, it could have a disproportionately negative effect on your portfolio.
Furthermore, your money may not enjoy the growth potential it might if it was invested in other sectors or regions.
5. Hindsight bias
Hindsight bias is the misconception that a past event was predictable and obvious. As a result, you might think future events are more predictable than they really are, which may result in overconfidence.
For example, you might think you understand why markets have been bullish or bearish in the past and invest based on this. The problem is that even if you’re correct, you can never rely on past performance and the same set of circumstances may produce completely different outcomes.
Get in touch
Please remember that this is only a small number of biases that could affect your investment decisions, which is why working with a financial planner is a good idea. A planner can provide a much needed second opinion and even act as a sounding board, and help you understand when you might be falling foul of biases that might lead to a costly decision.
At Citywide Financial Partners, our ongoing working relationship with you means we gain a better understanding of you and your thought processes. As such, we can provide bespoke solutions that help you meet your financial goals and explain it in a way that provides you with the confidence to make better decisions with your wealth.
If you would like to discuss your investments, or how we could help you make decisions you’ll thank yourself for down the line, please email firstname.lastname@example.org, we’d be delighted to help.
This blog is for general information only and does not constitute advice. It should not be seen as a substitute for financial advice as everyone’s situation will be different. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The information is aimed at retail clients only.
Investments carry risk. The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.