Investment decisions by humans are often subject to mental and emotional biases. To become a successful investor, it is critical to understand and overcome the common biases that often lead to poor decisions and ultimately losses.
To be a successful investor over the long term, it is critical to understand, and hopefully also overcome, common human cognitive or psychological biases that often lead to poor decisions and ultimately losses.
Investment decisions by humans are often subject to mental and emotional biases. Mental biases are generally involved in the notions that may or may not be true. Emotional biases occur spontaneously depending on your personal feelings at the time investment decisions are made.
The most common biases that occur are :-
Loss aversion bias.
It is a human tendency to feel more intensely about the losses as compared to the gains. Loss aversion bias is the tendency to avoid the losses over maximizing gains. Let us consider an example. An investor invests equally in two stocks X and Y. Stock X goes up by 50% while Stock Y goes down by 50%. The investor will surely feel the pain for Stock Y which goes down by 50% rather than being happy about Stock X which has gained 50% in intraday. These emotions may lead to a poor investment decision.
Herd mentality.
Doing something just because others are also doing so i.e. the tendency to follow the herd can often lead to irrational investment decisions. This is often driven by peer pressure and the urge to catch up with others and not feel left out. It may many times lead one into undertaking more risk than warranted.
Recency bias.
It is the tendency to give importance to recently acquired information and ignore long term fundamental statistics. Investors sometimes do not research the stocks deeply but only go after short term gains. One should go deep dive into what the company is up to before investing in it so that the loss margin decreases.
Confirmation bias.
Some investors tend to have a belief about the market condition and often gravitate towards information sources that confirm it. Such investors would usually invest in a stock after watching the opinion in different media sources. With this tendency, investors may end up buying too much stock without adequately diversifying their portfolio.
Mental accounting.
It refers to different personal strategies that people adopt in investing money based on their subjective criteria. For example, one might strategize to invest monthly salary in safe investments, while using the windfall gains for speculative purposes. They wouldn’t mind losing money on the latter. Similarly, yearly bonus or tax refunds might be viewed differently, while it is a part of one’s income. Such investment biases may not always guide you towards rational decisions.
Information bias.
It is a tendency to evaluate information even when it is irrelevant in understanding a problem. In this information age, there is an abundance of data from financial commentators, newspapers, stockbrokers, etc. and it may become difficult for investors to distinguish the relevant information from the irrelevant ones. In many instances, investors make decisions about buying and selling securities on the basis of short-term movements in the share price. Such pieces of information may actually be irrelevant in determining the stock’s true value over the long run.
The tendency to oversimplify.
To understand complex matters better, one has to divide it into smaller parts. But sometimes the matters are inherently complex and cannot be reduced to simple calculations. In the words of Albert Einstein, one should remember to make things as simple as possible, but no more simple. Thus, a key to successful investing is to stay within your ‘circle of competence’. One may consider concentrating on investments in areas that exhibit a high degree of predictability and be wary of areas that are highly complex or highly uncertain.
Hindsight bias.
It is a tendency to see beneficial past events as predictable and bad events as not predictable. Such is considered to be a dangerous state of mind as it can cloud one’s objectivity in assessing past investment decisions and inhibit learnings from past mistakes.
Restraint bias.
It is the tendency to overestimate one’s ability to show restraint in the face of temptation. This is more often associated with eating disorders. Most people are wired to be greedy and want to be ‘sure winners’. For many people, money is the ultimate temptation. But ‘sure thing’ investments are rare and many investments are sensitive to changes in assumptions, particularly macroeconomic assumptions.
In investing, what is comfortable is rarely profitable. – by Robert Arnott