When it comes to investing- behavioral biases are one aspect of investing that govern a lot of decisions that investors make. behavioral biases are preconceived notions, often irrational, that unconsciously affect investing decisions. In this article, I will take you through the 5 common behavioral biases exercised by investors, how to avoid them. Read On!
In this article
#1: Overconfidence Bias
This is the most common type of bias found in investors, typically the ones who have been in the game for a while and have tasted success.
Overconfidence exists in two forms- overconfidence in the decision they make and overconfidence in the information they receive.
In the former case, Investors often take risky bets and focus on one stock or a trend way more than they should, and often end up trading too much or too little in the same thought.
In the latter case, the investor blindly believes the information they receive regarding any investment scheme, which seems quite attractive.
Other telltale signs that your decision-making abilities are clouded by overconfidence bias include:-
- Being too sure of their ability to predict their markets due to past successes and making impulsive decisions as a result.
- Having the ‘illusion of control’- believing they are in control of the situation when they are not and the inability to assess and manage risk as a result.
- Not diversifying enough by favoring certain stocks or securities only as they may have given you good results in the past.
- Missing external cues that signal to exit the stock and being overly optimistic about your investment.
How To Overcome Overconfidence Bias?
- Take a more objective approach to your investments rather than an emotional one. Rely more on the data rather than hearsay and ensure that whatever you are investing in, is in correct alignment with your financial goals.
- Diversify to minimise your risk.
- Know when to sell a stock no matter how emotionally invested you are in the company. Obvious red flags include a shift in fundamentals, consistent underperformance, etc.
- Focus on investments that are reliable by conducting a background check.
- Keep learning and be intellectually humble.
#2 Holding On Bias
One of the deadliest biases in investor behavior is the holding on the bias.
How often did it happen to you that you believed deeply in a particular investment and kept holding on to it even when the results were not so good?
Even though this investment has done nothing but brings your entire portfolio down, you believed it would recover and hold on to it longer than you should have.
This inability to let go of a bad investment is called the holding on the bias. Here, the investor is too sure of or is too closely attached to a particular investment that he or she cannot see the harm it is causing, or even if they can see they choose to ignore it.
How To Avoid Holding On Bias?
You must set certain rules and instructions for yourself that enable you to evaluate an investment fairly and by any chance, you are biased towards it, you will get to know when is it the time to let it go.
For example, you can fix a certain percentage say 65% to be the endpoint of holding on to an investment. If that stock loses its value more than 65%, you will know now is the time to sell it off. Also, do not play with these rules. They should be unalterable for all your investments irrespective of how favorite one of them could be.
#3 Bounded Rationality and Recency Bias?
This is a well-recognized bias in the field of investment behavior. To be precise, humans have an extremely limited attention span which leads to impulsive decision making. Bounded rationality is the concept of making rational decisions with the limited or bounded knowledge we possess.
Neither do we have the time nor are we interested in conducting deep research, and so, base the majority of our decisions on the limited knowledge we gather from interactions and reading news and articles.
Hence efficiency gets replaced by comfort and satisfaction. News media and social media play a vital role in passive communication. Essentially, you are choosing what is being fed to you. This generates another type of bias called Recency bias.
Recency bias is choosing a stock or mutual fund that is being talked about the most or is ‘trending’. Investors often fall in the trap of media- social media, news media, financial media, and interactions with family and friends.
It is obvious that you get a soft corner for the name you hear most often and all doubts get shunned if you hear your friends praising a particular investment type or stock.
How To Avoid Bounded Rationality and Recency Bias?
It is important to understand that what suits someone may not suit your financial situation.
And so, taking shortcuts like investing based on a random ‘top stocks’ list that you see on the internet or in news, aping a successful investor’s portfolio or blindly investing based on a friend’s recommendation is not advisable.
You must ensure that all your money related decisions are well thought of and rational. There is a wealth of information about a company’s fundamental performance that you can find on the internet; use that to enhance your decision making.
You can refer to leading new-age investment platforms that offer you consolidated information on the company’s statistics/mutual fund’s performance as well. This may seem like a lot of work initially, but it’s still better than losing money in the long run.
#4 Confirmation Bias
When investors unconsciously build arguments or seek information that supports their preconceived notions about an investment opportunity, they are said to be under confirmation bias.
In such situations, investors tend to resist conflicting opinions and close themselves to alternate viewpoints.
For instance, if I believe that a particular company or sector has great potential and I am rigid in my approach, I might overlook the obvious risks of investing in such a sector or refuse to believe that risks exist in the first place. This may lead to an overconfidence bias in turn.
How To Avoid Confirmation Bias?
As is the case with other biases, recognizing that you may have been under the influence of confirmation bias is the first step towards addressing it.
It is good to gather information about a particular sector or stock, however, while shortlisting a company, make sure you have all the facts in front of you. This means assessing the investment option objectively- both pros and cons.
#5 Chasing Past Returns
This is by far the most adversely affecting biases of all times that investors suffer from. Chasing past returns is one thing that will always view investments from the lens of the past.
Researchers have found that a majority of investors base their investment decisions predominantly on the previous year’s returns. It has become a fact that past performance is not reflective of future performance. Yet, investors fail to implement this in their investments. In fact, most seasoned investors bet on their investment decisions, which are based on past performance.
Yes, trend reading and pattern reading is a science but it does not fit everywhere, at least not in the financial markets where there are so much volatility and uncertainty. And even if you happen to find out the trend by any chance, the markets are unarguably unpredictable.
So the right approach is to be mindful of the fact and assess a company based on its underlying strengths and whether it falls in line with your investment objectives.
To Sum Up
Before you choose your investments, make sure that you are not under the influence of any of these investment biases. Behavioral bases have a lasting effect on the investor’s performance and can lead to a dent in your investment history. Be radical and aware and invest smartly.