Artificial intelligence (AI) tools like ChatGPT have hit headlines recently as people find all kinds of innovative uses for them.
It seems like every day there is a new story about students using AI tools to cheat in exams or computer-generated images winning art competitions. And AI is making waves in the financial world too.
Indeed, many people are excited about the prospect of using an “AI fund manager” to help choose investments. While those in the industry maintain that software cannot replace fund managers, there is no denying that the ability to analyse data and make predictions is very valuable.
Perhaps more importantly, a piece of AI software won’t let emotions get in the way of those predictions.
While, in many situations, the lack of humanity is the downfall of AI applications, the opposite could be true when choosing investments. By taking the emotion out of investing, you may be able to make more beneficial decisions, especially in uncertain times when you could be more prone to emotion-led responses.
However, AI is still in its infancy, and it is not likely to be running your portfolio in the near future. So, in the meantime, you may need to be aware of how your emotions could be affecting your judgement. Read on for five interesting ways.
1. Loss aversion
Investments always carry some risk, and learning how to manage that is a crucial part of your strategy. Before choosing any investment, you may want to consider whether it aligns with your goals and whether the potential gains are worth that level of risk.
However, some investors fall victim to “loss aversion” – the tendency to prioritise avoiding loss over seeking profits. The theory posits that humans feel the pain of losses twice as strongly as the pleasure of gains.
When you let the fear of losses guide your investment decisions, you may avoid small risks, even if they are likely to benefit you in the future.
Keeping your money in a savings account rather than investing it during a period of high inflation is a prime example of this. While cash savings will likely generate some interest, your wealth could lose value in real terms due to inflation.
Investing your wealth, on the other hand, may help it grow faster than inflation. So, accepting some risk could be a more effective way to protect your wealth than taking the “safe” option.
2. Herd mentality
In the late 1990s, when the internet was in its infancy and the world speculated about how it might change our lives, investors saw an opportunity.
Once a few investors started pouring their money into internet-based startups, “herd mentality” set in and many others followed suit. Scores of investors threw caution to the wind and backed any tech startup they could find, without doing much research, in the hope that they would eventually become profitable.
But, after a temporary boom, the bubble burst and investors faced huge losses, often on reckless investments.
The dotcom bubble demonstrates the danger of listening to trends and following what other investors are doing instead of sticking to your own unique financial plan.
You may need to be especially aware of this in times of economic turmoil because panic drives herd mentality. For example, lots of people may sell investments during a market downturn and if you follow suit, you could miss out on gains as and when markets recover.
That’s why it can often be better to take professional advice about your investments and stick to your own financial plan instead of following the crowd.
3. Confirmation bias
You’ve previously read about the story of GameStop, where amateur investors promoted and bought stock in US retailer GameStop, driving up the price and forcing hedge funds to close shorted positions and lose billions of dollars.
While early adopters saw significant gains, many who were late to invest lost a lot of money when the bubble burst.
Unfortunately, in their online echo chamber, these investors maintained that GameStop stock was a safe investment, even when many people warned that the value would soon plummet.
In other words, they fell victim to “confirmation bias” – a tendency to listen to information that confirms your existing beliefs and ignore everything else. Those investors discounted any evidence that GameStop was a huge risk because it did not align with their existing beliefs.
To avoid falling into this trap, you may want to spend more time researching investments, and approach decisions with no preconceptions.
4. The Semmelweis reflex
The “Semmelweis reflex” causes us to reject evidence because it contradicts an existing paradigm.
The term comes from the name of 19th century Hungarian physician Ignaz Semmelweis who discovered that child fever mortality rates fell tenfold when doctors disinfected their hands with a chlorine solution before moving from one patient to another.
While Semmelweis’s procedure saved many lives, and despite the overwhelming empirical evidence, his fellow doctors rejected his hand-washing suggestions, often for non-medical reasons.
If you are assessing the investment potential of a startup and you find that the business model is entirely different from other successful competitors, you may fall victim to this cognitive bias and decide that the company will fail, even if the evidence suggests otherwise.
Your past experiences cloud your judgment of the current situation, and it’s easy to make assumptions. Additionally, you may overlook evidence to the contrary, like promising sales forecasts for the business.
This is a natural response as we all view the world through the lens of past experience, but this may limit you when making investment choices.
You may find that doing more extensive research and making a judgement based on the specific investment, rather than comparing it to past experiences, can lead to more informed decisions.
5. The house money effect
The “house money effect” refers to a gambler’s behaviour after a big win at a casino. They tend to make riskier bets because they believe they are playing with “house money” rather than their own.
While long-term investments are normally more reliable than a roulette wheel, the house money effect still catches people out. In many cases, you may be more likely to take big risks with reinvested capital if you see significant returns because you perceive any losses to be less damaging.
However, you may want to remember that it was your measured, long-term approach that generated those returns in the first place.
So, instead of diverging from your plan, stay the course and you will hopefully continue to see that long-term growth.
Get in touch
It is easy to let emotions cloud your judgement when making investments decisions, but we can help you to stay objective and stick to your long-term plan.
If you want to know more, email firstname.lastname@example.org or call us on 01189 876655.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
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. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.