In both life and investing, being biased can undermine your goals and hard work. Cognitive and emotional tendencies can lead investors to make irrational and suboptimal decisions. It’s imperative for investors to be aware of any potential biases they may have, work to mitigate their impact, and follow a disciplined approach when investing. The following are five common biases that all investors should be aware of and ideally avoid.
Loss Aversion Bias
The loss aversion bias pertains to the tendency to feel the pain of investment losses more strongly than the satisfaction of reaching equivalent gains. This causes investors to acutely prioritize and focus on avoiding losses overachieving growth. This fear of loss can lead to poor decision-making, such as selling a winning investment too early, or holding onto a losing investment for too long in order to avoid the psychological discomfort associated with the loss, in hopes that it will reverse course.
Confirmation bias is when an investor gives more weight to information that confirms their pre-existing beliefs or opinions. The investor tends to ignore, discount or downplay information that contradicts their views, which could lead to overconfidence, an inability to accept other perspectives, and ultimately poor decision-making.
Anchoring bias happens when an investor relies too heavily on a specific data point when making decisions. For example, a stock is trading at $50 and is down from its all-time high of $100. An investor anchors his or herself to the $100 price point and buys the stock at $50, assuming they are getting a great deal. In doing so they fail to consider a host of relevant metrics, such as current market conditions and the company’s fundamentals, to name a few.
An overconfident investor tends to overestimate their ability and knowledge when it comes to investing. Believing you can consistently predict and beat the market can cause you to underestimate key risks. The overconfidence bias can cause investors to trade excessively or take on undue risk in the portfolio.
The herding bias refers to an investor’s inclination to follow the crowd and invest based on what others are doing instead of performing their own research. This bias is more common during periods of market turbulence. It can even contribute to the formulation of market bubbles or crashes, as large numbers of investors all make the same choice without considering fundamentals.
When you consider all these forces playing on our investment decision-making, you can see why it is so hard to invest on your own, and so valuable to have a professional investment team working with you.