5 Most Common Biases in Investing (+Tips on How to Avoid Them)

October 12, 2023

Every day we have literally millions of decisions to make, of which we are not even aware - a large part of them our brains make unconsciously, guided by previously established patterns.

This kind of actions were described by the all-too-famous psychologist and economist Daniel Kahneman, who was awarded the 2002 Nobel Prize for his discoveries in the area of behavioral economics and decision-making processes.

However, how does his discoveries relate to the stock market? The behavioral biases unfortunately also apply to investment decisions. Investors tend to decide on their finances based on fears and early experiences - and while they think their behavior is supported by long and extensive analysis, in many cases the actions they take are not entirely rational.

In today's post we suggest what you should pay special attention to in order to stop losing money and record significant profits - in full consciousness! Knowledge is always the key to success - because even if you make some mistakes, you need to know what they were so that you can draw the right conclusions for the future.

Understanding behavioral finance

Before we get to the heart of the problem, let's answer the question of what behavioral finance really is.

According to experts, it's a type of science studying the psychological factors affecting investment decisions - basically, how to interpret the information obtained and certain mental shortcuts that accompany the whole process of deciding to bet on a particular investment.

Such cognitive biases can distort judgments - resulting in poor investment decisions.

What's even worse, without understanding why we actually made such a decision, we can't learn from it and improve in the future. Remember: investment decisions made unconsciously using these mistakes are always weaker - and without realizing the existence of these cognitive pitfalls, you can't even learn from the mistakes you've made, because you don't realize what specifically resulted.

Behavioral finance - definition.

Of course, there are many investing biases that lead investors down a blind financial alley, and it would be difficult to describe all of them in one text - which is why in today's post we'll take a look at the following five common cognitive biases affecting stock markets decision making process!

Investment decisions: what to watch out for?

Below you will find a list of selected investing biases - feel free to deep dive into behavioral finance and learn how a simple decision making processes can stand in the way of successful investors:

1. Overconfidence bias

The tendency to see ourselves as better than others (in this case - more competent and basically infallible investors).

Overestimating one's experience, knowledge, past performance or just skills, unfortunately, is a simple way to make rash investment decisions. Example? Some people claim to be able to accurately time the market, predict market crashes, or simply believe that after the initial successes comes the hope that "after all, it's easy," which can end up clearing the account by.... the next point, which is bad risk management.

It is very difficult to distinguish skill versus luck, especially at the beginning of one's journey towards successful investing.

Interestingly, this bias is so common that it has become the subject of numerous studies - as an article published in the renowned International Journal of Management in 2020 shows, people with this particular bias have significant problems with proper risk assessment.

How to avoid it: if you are just starting your adventure with investments it is worth consulting a professional who will help you analyze the adopted investment strategy. It is also worth betting on automated tools that will help you make rational decisions on the basis of reliable data - kind of an unbiasad reality check with complete disregard for emotions.

App allowing for bias-free stock picking - fundamental scoring view from tool.

2. Confirmation bias

Overconfidence bias often goes hand in hand with confirmation bias. People tend to have their own opinions and beliefs - which they escalate into the investment decisions they make, seeking confirmation of them, while ignoring data that is contrary to their concepts. Ergo - they react only to confirmation of their own rationale.

However, how does this look in practice? Imagine that we have some company in our portfolio, supposedly we want to decide whether to keep it or not, but subconsciously we want to keep it for ourselves - so the "analysis" just boils down to finding arguments "for" and looking for why the arguments "against" are unimportant, e.g. a poor track record of some analyst who criticizes a particular company, or if a lot of people say it's better to sell, it's clear that the crowd is stupid (just when we want us to be the smarter ones).

The solution: What really helps you to avoid this bias is to read conflicting opinions coming from various sources of information. You need to learn about different judgements and points of view - while still expanding your expert knowledge. Take our word for it - different pinions contrary to yours own have a high value also in the investment world, no matter if you're investing in mutual funds or dividend companies.

3. Mental accounting

The emotional bias of treating money in different ways - depending on what source it came from and what we intend to use it for in the future.

In short - we create certain "mental accounts" for various uses, such as money for a house or money for the proverbial "fun". We treat a $100 bill earned from work differently - and a bill found on the street differently, even though both amounts have the same face value.

The solution: create a financial plan that you will stick to. Thanks this, you will know exactly how much money you have for investing and how much for current expenses. In addition, decide right away what you want to do with extra unexpected money, such as discretionary bonuses at work.

4. Loss aversion bias

Classic example of a cognitive bias related to low risk tolerance. It is a predisposition toward simply avoiding losses in lieu of seeking new gains.

This bias is the tendency to not take even a minimal risk, which de facto is definitely worth it. It is also often the reason for holding on to savings of further investment in spite of the fact that, at the very least, inflation is pushing their devaluation. So people don't look at the long time horizon - this is also a mistake made sometimes by new stock investors, who move money too quickly instead of waiting for a measurable result.

Robert R. Johnson Risk quote

The solution: learn to accept risk. This will be helped by a well-chosen investment strategy, which in the beginning can be based on proven companies and markets - for example, an index fund that follows the S&P 500. Don't fall prey to your own medications - make bold investing decisions to become a better and better investor.

5. Recency bias

Loss aversion is unfortunately often combined with so-called recency bias, consisting of placing too much emphasis on recent events: falls in the stock market, a sudden rapid increase in the value of a given company, etc. This often results in actions taken in panic, such as reckless selling of shares.

Investing experts, among visualizations of how this bias works, give examples such as tilting an investment portfolio more heavily exclusively toward U.S. stocks after a repeated lack of satisfactory success in international markets or the example of over-reliance on a mutual fund's recent performance history when making a buying decision.

For example, this also applies to articles we've read or even tweets - we take what we've seen recently as a universal and valid point of view for the rest of the market.

The solution: Don't be afraid of losing or missing an opportunity that appears on the market. Hasty decisions lead people to a situation where they buy high and sell low. It may also be a good idea to build a portfolio with asset allocation to different asset classes - and stick to the decisions made. This will also allow you to avoid herd issues - sometimes going against the grain, even though seemingly less logical, will give good long-term results.

Summing Up...

Behavioral finance is a complex field, showing that when we seek quick gains - we can unconsciously underestimate traditional finance theory and take financial shortcuts, unknowingly implementing quite a few cognitive biases. Instead of betting on a well-diversified portfolio - we make financial decisions without looking at market conditions, instead guided by personal beliefs and emotional attachment. We underestimate the value of others' opinions, instead overestimating the potential risks. We focus on our own investment experience rather than reading about new financial products or market conditions. We miss the specifics, while betting on confirmation bias, overconfidence bias, loss aversion bias, mental accounting & co.

Let's remember that losing investment is sometimes just a few minutes of lack of thought and analysis - so it's worth stopping for a moment and getting rid of emotional reactions.

Of course, we know that today's text has not exhausted the entire pool of emotional biases that relate to making money - so already from here we invite you to the next post in this series, in which we will describe other behavioral biases such as: familiarity bias, herd behavior bias, anchoring bias or availability bias.

Stay tuned - and make financial decisions based on market conditions and profesional complimentary consultation!

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