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They say to err is human. It is equally true, but less likely acknowledged, that bias is also a human trait. Everyone has biases – whether we recognize them or not and whether we admit it or not. The burgeoning field of behavioural economics offers dozens of human foibles that are fascinating because many of them contradict the basic assumptions of traditional economics. Human psychology plays a bigger role in investment decisions than many of us care to admit.

Of the many biases we possess, there are four that pose particular problems for investors. They are loss aversion, overconfidence, illusion of control and representativeness. Understanding the impact of each can go a long way to improving your decision making.

Loss aversion is obvious. No one likes losing money, but different people will go to interesting lengths to avoid being down. Also known as prospect theory, this research shows that the pain of a loss is felt twice as acutely as the joy of a gain, which is mostly because people tend to expect gains, so it’s not remarkable when they happen. But people will go to great lengths to avoid triggering losses, which can exacerbate the problem. Sometimes, cutting your losses is your best alternative.

Overconfidence is one of the best-known and intuitively obvious biases. It is natural for people to think they are better than they really are at all sorts of things. Whether it’s investing, driving, or golf, people consistently overrate their abilities. The problem with having such a high opinion of oneself is that you might unwittingly take more risk than you think you’re taking because you believe you can outperform. The effects of this bias could become immediate and extreme if markets continue to tumble as they have through much of 2022.

Next up is the illusion of control. It’s a first cousin of overconfidence. People are overconfident because they think they have more control over things than they actually do. It’s like wearing a lucky tie to help you carry the day on agenda item No. 4 at the big team meeting, or that by just knowing someone on the board of a public company somehow provides you with meaningful insight into the company’s prospects. In fact, many things in life are more random than we want to admit, but somehow, we’re inclined to deny things that are obvious.

Finally, we come to representativeness. How much does your personal experience reflect how things are? There’s a reason why pollsters typically interview more than 1,000 people when doing a poll. Sample size matters and small samples can provide wildly divergent and misleading viewpoints. Once you get enough data, the margin of error (for example, valid within 2.2 per cent, 19 times out of 20) may allow for true insight into what we might reasonably expect about something. If you get really lucky or unlucky with a stock pick, it might make you think you’re better or worse than you really are – and it’s all based on that single experience.

There are plenty of other biases too, but these four are among the most pernicious for investors. Taking a step back to reflect on how you see yourself in these vignettes can help you keep biases in check to make sound, well-reasoned decisions.

John De Goey is a senior investment adviser and portfolio manager at Wellington-Altus Private Wealth Inc. His views are his own and not necessarily those of Wellington-Altus and do not constitute a recommendation.

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