Everybody has biases. We make judgments about people, opportunities, government policies, and of course, the markets. When we analyze our world with our own biases, we put our observations through a number of filters manufactured by our experiences. For most people, it is impossible to be unbiased in investment decision-making.
There are generally two prevalent types of bias: Cognitive (biases based on faulty cognitive reasoning) & Emotional (biases based on reasoning influenced by feelings or emotions).
For most people, it is impossible to be unbiased in investment decision-making. However, investors can mitigate biases by understanding and identifying them, then creating a trading and investing rules that mitigate them when necessary. Broadly, investing biases fall into two main categories: cognitive and emotional. Both biases are usually the result of prejudice for choosing one thing over the other.
Cognitive Bias:
- Confirmation Bias: Have you noticed that you put more weight into the opinions of those who agree with you? Investors do this too. How often have you analyzed a stock and later researched reports that supported your thesis instead of seeking out information that may poke holes in your opinion?
- Gamblers’ Fallacy: Let’s assume that the S&P has closed to the upside five trading sessions in a row. You place a short trade on the SPDR S&P 500 (SPY) because you believe chances are high that the market will drop on the sixth day. While it may happen, on a purely statistical basis, the past events don’t connect to future events. There may be other reasons why the sixth day will produce a down market, but the fact that the market is up five consecutive days is irrelevant.
- Status-Quo Bias: Humans are creatures of habit. Resistance to change spills over to investment portfolios through the act of repeatedly coming back to the same stocks and ETFs instead of researching new ideas. Although investing in companies you understand is a sound investment strategy, having a shortlist of go-to products might limit your profit potential.
- Risk-Averse Bias: The bull market is alive and well, yet many investors have missed the rally because of the fear that it will reverse course. Risk-averse bias often causes investors to put more weight on bad news than good news. These types of investors typically overweight in safe, conservative investments and look to these investments more actively when markets are rocky. This bias can potentially cause the effects of risk to hold more weight than the possibility of reward.
- Bandwagon Effect: Warren Buffett became one of the most successful investors in the world by resisting the bandwagon effect. His famous advice to be greedy when others are fearful and fearful when others are greedy is a denouncement of this bias. Going back to confirmation bias, investors feel better when they are investing along with the crowd. But as Buffett has proven, an opposite mentality, after exhaustive research, may prove more profitable.
Emotional Bias:
- Loss-Aversion Bias: Do you have a stock in your portfolio that is down so much that you can’t stomach the thought of selling? In reality, if you sold the stock, the money that is left could be reinvested into a higher-quality stock. But because you don’t want to admit that the loss has gone from a computer screen to real money, you hold on in hopes that you will, one day, make it back to even.
- Overconfidence Bias: “I have an edge that you (and others) do not.” A person with overconfidence bias believes that his/her skill as an investor is better than others’ skills. Take, for example, the person who works in the pharmaceutical industry. He/she may believe in having the ability to trade within that sector at a higher level than other traders. The market has made fools out of the most respected traders. It can do the same to you.
- Endowment Bias: Similar to lose aversion bias, this is the idea that what we do own is more valuable than what we do not. Remember that losing stock? Others in its sector may show more signs of health but the investor won’t sell because he/she still believes, as before, it’s the best in its sector.
By understanding and recognizing these biases in ourselves, we can take action to mitigate negative outcomes. An investment advisor that is able to successfully implement this can keep a steady hand on the long term growth of his investments.
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