Although it’s not commonly a major concern for an investor, investor biases are very common and they affect them very much. These biases can cause small to tremendous errors in an investor’s judgment. And if you think you have them, you have to start avoiding them now before they get the better of you.
According to behavioral finance, it’s normal to have these biases. But that doesn’t mean we should just let them exist in us. It’s important that we get rid of these biases if we want to start gaining something meaningful out of the market.
In this article, we will focus on the most common investor biases, and then we’ll tackle some good way to avoid them. Sit back, grab a bucket of popcorn, and read on!
Anchoring or Confirmation Bias
We all know that first impressions are hard to shake off. This makes us selectively filter and pay more attention to information that backs our opinions. We favor and listen more to insights that validate our beliefs and first impressions.
It’s very much the same when it comes to the world of investing. It’s very easy to “anchor” or stick to preconceive information and dismiss contradictory parts. Some investors completely disregard opposing views and information to their first impressions.
For instance, an investor may begin investing thinking that the market conditions are in his favor just because the first set of info he obtained supported this view. If he has a bad case of information bias, he will tend to disregard evidences that the market is longer favorable for him.
It’s easy to see other unpleasant effects of such bias. For one, the investor will probably be vulnerable to “surprise” market movements, which he would have foreseen if he only paid attention to opposing views.
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Regret Aversion Bias
Regret aversion bias refers to a person’s tendency to avoid potentially regrettable actions because of past negative experience. The person shies away from risky situations in fears of repeating the same mistake and having to regret the action again.
In other words, the investor loses trust on his ability to take on risks and come out unscathed.
Applying this principle to investing, an investor with regret aversion bias would probably not want to part with a stock in which he had already made big losses. The reason? He simply doesn’t want to admit the fact that he has lost the investment. He doesn’t want to admit it merely because he doesn’t want to regret anything.
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Humans are definitely social animals. We fear missing out on the hottest and latest fads and fancies. People in general want to be in agreement with other people. However, with such “need to belong” comes a generally unhealthy bias, which is called the herd mentality.
Herd mentality refers to the unreasonable urge to go with whatever flow the people are leading to. For real life examples, marketers know that most people crave for validation and some amount of social proofing.
They use this to their advantage by making buyers think that since many other people like a product or service, so should they. This method of creating social proof succeeds in convincing the person that he has a certain need that other people also have. And that he should answer to that need, just like the other people, by buying a certain product.
You can also see this bias on people who have a severely huge and nagging fear of missing out.
And you can also see this on investors who don’t like missing out on the latest market trends. If an investor has this bias, he will probably be in hot pursuit of a stock that everyone else is going after, even though he doesn’t fully understand the current market situation.
Some investors get pressured or get too much influence from their peers to follow trends or buy certain items. They do it without pausing and asking themselves if they really need the stock. Even if they ask that, they fail to realize that they don’t always have to come up with a decision right off the bat.
You can see this bias in HD quality when you hear someone saying “I knew it!” even though that person was just as clueless as you before something happened.
Even though this doesn’t seem to have a direct effect on the investment, there can be detrimental situations. For instance, if a investor completely believes he knew something would happen even before that thing happened, that investor would probably put too much weight on the his next prediction.
It’s part of human nature to overestimate or wrongly calculate the accuracy of their decisions. But if you’re an investor, this may not only translate to a one-time loss. Such bias can cos the investor huge chunks of his capital, or worse, all of it.
It’s also very normal for people to choose the familiar and comfortable. Just imagine attending a congregation of a hundred people whom you haven’t made acquaintance with. You would probably search for someone even remotely familiar and stick to talking to that person.
In the context of investing, an investor with familiarity bias gravitates toward familiar or well-known investments. And this doesn’t mean an investor who’s studied an investment severely. This refers to an investor who doesn’t feel comfortable with the idea of investing perceivably unpopular stocks (at least to him).
In most cases, this bias stunts the investor’s learning curve. The investor wouldn’t be willing to try out a new investment even though he’s made thorough research about it. He wouldn’t feel comfortable investing in that stock even though the fundamentals all glow green lights. The reason? He just isn’t familiar with it.
How to Avoid Investor Biases
Now that you know the most common investor biases bugging investors like you, it’s time to start ghosting them. You ought to do that before they start hurting you and your investments.
Obviously, the first step to avoiding investor biases is to acknowledge their existence. Maybe not in you, but in the investing populace in general. Once you’re aware of their existence, you’ll start wondering and looking over your shoulder if you have them.
Here are some other useful tips that can help you ditch your biases:
Control your Emotions
Emotions play a huge part in an investor’s day to day decision-making. It’s reasonable, though, to be alarmingly emotional about your trades. After all, it’s your money you’re risking.
However, if you let your emotions constantly bog you down, you won’t go anywhere. You’ll probably make more losses than gains. Investing needs intellect and sound analysis.
Learn to manage your emotions properly to avoid being a victim of your biases. One good way to do that is the so-called process of compartmentalization. Compartmentalization is a process that lets you inhibit unpleasant or disruptive cognitions. You can then deal with the more important investing issue at hand, and deal with that unwanted emotion later.
Listen to Different Opinions
If you think you have the confirmation bias, you need to start listening to views contradicting your opinions.
You can start by isolating what you actually believe in. Determine the strong points of your beliefs, if there are. Then, seek out people who can give you opposite views and determine whether theirs outweigh yours.
It wouldn’t be easy to admit if your views didn’t hold up. But just remember that you’re doing yourself a big favor when you ditch your incorrect views and favor a sounder one.
Don’t Go After Yesterday’s Winners
Many investors commit the mistake of ignoring the truth of the dictum “past performance doesn’t guarantee present success.” That’s why investors chasing after yesterday’s winners are quite common.
Recent success doesn’t guarantee future rampage if the fundamentals are not saying so. Try not to bet on a stock that exhibits great performance now but has a blurry outlook. Instead, study it fundamentally.
Analysis beats the Story
We all love good, exciting, heart-pumping stories. But in terms of investing, stories weigh like feather when compared with detailed analysis. Do not let narratives decide for you.
In the world of investing, the market can easily sway you into believing a story if enough people are repeating it. This also feeds biases in investors, pulling them further away from the art of being logical.
It’s okay to listen to stories, though, as long you know when that story ends and reality starts. Take time to study fundamentals and check charts and indicators. Rebalance your portfolio. Keep close tabs on economic reports. Compare different assets. Check your risk tolerance.
Investor biases are what make the market seem illogical and unreasonable, say the proponents of behavioral finance. And the goal in here is to know which biases greatly affect you (so you can get rid of them) and the market (to use them to beat the cunning market).
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