Behavioral biases, or deeply embedded mental shortcuts, can undermine even experienced investors. This guide unpacks common investor bias types and shares strategies for overcoming them.
Anchoring bias refers to relying too heavily on the initial piece of information when making decisions, while herd mentality occurs when investors follow crowd into speculative bubbles or panic when the market dips.
Confirmation Bias
Relying too heavily on information that confirms one’s existing beliefs or hypotheses while dismissing information which contradicts them can distort investment decisions, leading you to depend on only one source for news or give more weight to analyst reports that agree with your view, for instance.
Bias can also lead to missed investment opportunities by being too fixated on how an industry, stock or market trend will perform in your mind. Furthermore, this mentality could keep you holding onto losers too long in hope of an unlikely turnaround that might never materialise.
Other behavioral biases that can hinder decision-making include hindsight bias (seeing past events as more predictable than they actually were) and overconfidence bias (having too much trust in oneself). To counter confirmation bias, try reading multiple sources with differing opinions; avoid depending on one source alone for making financial decisions, and consider consulting an impartial source, like a registered financial advisor, to assess your thinking process.
Availability Bias
Availability bias refers to a cognitive bias where individuals overestimate the significance of partial information due to its ease of availability. Investors frequently rely on more recently acquired or vivid details when making decisions, sometimes overlooking important historical data and trends that could provide more meaningful context for making wiser choices.
Investors with herd behavior tend to buy stocks which have recently experienced price surges or sell when prices decline, assuming their trend will continue. Such herd behavior can result in market bubbles that eventually burst.
To combat herd mentality and other behavioral biases such as optimism/pessimism bias or the endowment effect, be sure to rely on multiple sources for market information and invest in companies you understand well. Doing this will ensure you avoid falling prey to herd mentality as well as optimism/pessimism bias or the endowment effect. Finally, think carefully about your risk tolerance level and consider your willingness to risk as this will help determine an acceptable level of risk for yourself.
Loss Aversion
Loss aversion is a cognitive bias in which we take greater pleasure from gains than losses of equal magnitude. Consider this: If you were to drop $10 into the street and find it again later, its loss likely would feel far more painful than its recovery would bring joy and satisfaction.
Loss-averse investors tend to avoid taking risks that might help further their financial goals, even when doing so could benefit their portfolios. They might hold onto failing stocks too long or sell successful ones too quickly in order to prevent possible loss from their portfolios.
To overcome loss aversion, approach investment decisions with an open mind. Engage in “what if?” type conversations with yourself or financial professionals – asking “what if” questions may help to open your eyes to different points of view and help make informed choices while limiting negative investment outcomes.
Anchoring Bias
Anchoring bias occurs when making decisions based on the first piece of information received or considered, which may lead to irrational investment choices.
Example: Imagine shopping for a new car and the salesperson offers you an initial high price, which serves as your anchor point. When they then offer you a lower price that falls below it, you will perceive it as being a good deal – however it might not be.
Anchoring bias can be especially problematic when investing in stocks or other assets. When exposed only to positive news about a particular stock, it’s easy to become attached at $100 per share and miss out if its share price dips to $50; critical thinking skills and seeking diverse opinions can help avoid anchoring bias, while setting objective criteria for purchasing and selling investments using fundamental analysis can provide further protection from anchoring effects. Adaptability in adapting investment strategies according to changing market conditions also aid in protecting investors against anchoring bias.
