Avoid Investment Mistakes: Learn Behavioral Finance
What biases do you have? If you say, "Not any!" that's highly unlikely. Your biases could cause you to lose money in the markets. Here's what you need...
This story originally appeared on MarketBeat
I was a psychology minor in college. Every time I come across an article about heuristic thinking or the availability bias, I always stop and read because they are so fascinating — and potentially damaging — to ourselves and even to our money.
Need an example of a bias? For example, let's say you said, "In 1997, I knew it was a good idea to invest in Amazon." You've told your friends and colleagues more times than you can count that you "just knew" then that the company would become a gargantuan enterprise. (And they gaze admiringly at you now, in 2021.)
If so, you totally got bit by the hindsight bias. This means you view a past event as being more predictable all along.
Psychological biases can destroy a portfolio or mangle a trading plan because we're, well, human. Let's explore the ways in which you get in your own way because of your biases.
What is Behavioral Finance?
Behavioral finance studies how psychological influences can affect market outcomes. You can use behavioral finance to understand the confluence and results of your own psychological biases and investing decisions.
Let's go over a few common cognitive biases that may affect your investing decisions so you can catch yourself in the act and do some damage.
When you suffer from confirmation bias, you go out of your way to look for information that confirms a conclusion or hypothesis you've already determined ahead of time. In other words, you might see a few tidbits of favorable news that makes it seem like you should trade a given stock. You might go as far as to ignore unfavorable news about the company you want to invest in.
This can result in the feeling that nothing will go wrong; you might refuse to see all sides of a problem. (This happens a lot in politics, when individuals only seek positive information about the side or candidate they support and consistently only listen to negative information about the opposing party or candidate.)
Tips to overcome confirmation bias:
- Purposely look for contrary opinions — even when you don't want to hear them! Understand the backstory as to why that particular person or entity has taken that position on a stock or company.
- Don't rely on one source of information and increase your investing knowledge.
Information bias refers to investors' tendency to look at all information, even useless information, in the context of investing and trading. Traders and investors see and hear so much information every day, from Twitter feeds to sound bites from market commentators, that it's often hard to understand which information should stay on the radar and which they should dismiss. The wrong information can lead you to sell excellent companies and buy into not-as-good companies.
Tips to overcome information bias:
- For investors: Ignore share prices that change daily.
- Hone in on the important kind of information when making trading and investing decisions and use sound metrics to determine the underlying fundamentals of companies.
Loss aversion means that by nature, people would rather not risk losing money over achieving equivocal gains. People will often avoid investing in a particular investment if there's a known possibility of loss — and that, irrationally, losses are bigger than similar-sized wins. This could lead to passing on investment opportunities for fear of experiencing loss.
Tips to overcome loss aversion:
- Define stop levels or targets in trading.
- Practice patience and learn to deal with your emotions.
Hindsight bias means that you see positive past events as predictable and negative events as unpredictable. Hindsight bias clouds objectivity. Here's how it might look: You buy a stock and the price falls. Afterward, you "just knew" it would fall. On the other hand, let's say you earn money for your efforts. Similarly, you "just knew" you made a great decision.
Tips to avoid hindsight bias:
- Keep an investment journal to learn from later.
- Choose a non-emotional, data-driven approach to investing.
- Avoid overconfidence.
- Expect the unexpected.
You know all about groupthink, or the bandwagon effect. (It's what your mom always warned you about — that dreaded peer pressure.) However, in the context of investing, when other people invest or trade in a particular stock or company, you may feel tempted to do the same because "everyone else does it."
The short-selling GameStop phenomenon earlier this year offers a great recent example of groupthink, when investors bought GameStop in droves when the news (and social media) shared enthusiasm for GameStop and many other companies.
Tips to overcome groupthink:
- Analyze on your own and think independently.
Restraint bias means you overestimate your ability to show restraint when temptation strikes. In other words, like gambling, you think you'll be able to control yourself when faced with a situation where you think you'll need to stop.
When you get the itch to keep trading, you may have the tendency to think, "I can stop at any time" or overestimate the amount of temptation they can really handle. This can even result in addictive behaviors, particularly when trading.
Tips to overcome restraint bias:
- Know your triggers in the face of specific situations.
- Work on impulse control.
Anchoring bias means you rely too heavily on a single piece of information — or the first piece of information you receive — when making a decision, such as the recent share price, or toward another arbitrary benchmark figure. When you use an anchor as a reference or starting point, you may overly rely on that specific piece of information when you make decisions.
For example, let's say you anchor your fair value estimate to the purchase price instead of the underlying fundamentals of a company and end up holding onto investments that lose value.
Tips to overcome anchoring bias:
- Set your own anchor based on your needs and goals.
- Take advantage of objective resources.
Become Aware of Biases and Irrational Behavior
As humans, one of the best things you can do is to acknowledge that you don't always think logically. We're all the victims of our own biases and constantly showcase irrational behavior — no matter how level-headed we like to think of ourselves.
When investing and trading, biases can signal the death knell for our money if we don't understand these (slightly irritating) behaviors.