How often have you made an investment decision based on ‘instinct’? And if you’ve made some money off that ‘instinct’, you might even have boasted about it to your family and friends.
But let’s face it, our instincts are often based out of emotions, mental biases, assumptions, and misconceptions. As much as winning based on instinct feels good, these intuitive inferences cannot substitute critical scrutiny, plain financial facts, and even common sense.
So, when we’re putting our hard-earned money in the financial market, it takes a little more than a sound understanding of finance to be able to stay ahead. It also requires an understanding of our mental and emotional biases, and how to overcome them. Knowing them will go a long way in helping you avoid making costly mistakes.
Greed and fear. The root of many mistakes.
Many studies, such as this, have found that greed and fear are the two dominant emotions in play while investing. These two emotions manifest themselves in numerous biases that we’ll be discussing below, but suffice to say, it often causes rational people like us invest in a hurry, or ‘abandon ship’ at the wrong time.
So, what exactly are these investment behavioural biases we need to be wary of?
1. The Overconfidence Effect
“Overconfidence precedes carelessness,” Indonesian author Toba Beta writes. We often deduce that we know all it takes to make a particular decision when the reality is that our knowledge isn’t as profound as the experts. We tend to self-certify the quality of our information, thus making us misinterpret critical information or fail to research further.
It’s been shown that overconfidence and complacency fuel excessive trading, which by no means is a guarantee for higher returns.
2. Myopic Loss Aversion
Another common emotional bias is an overwhelming fear of losses, which takes precedence over profit-oriented smart investment planning.
This panic-stricken approach motivates many amateur investors to sell everything off the moment they see a decline in prices, without much deliberation.
3. The Anchoring Effect
In many occasions, investors get influenced by certain information which anchors their future decisions. You may read a piece of news about a company or hear a ‘tip’ from a friend, and rely on it too much when making an investment decision.
For example, a family friend of yours tells you that they recently lost a lot of money in the stock market. Although you may not know the details of the episode, you may inadvertently feel that the stock market is too risky, and underweight equities in your portfolio as a result.
4. Reducing Regret
Nobody wants to regret their decisions, but investors usually go too far to ensure this. For example, investors often hold on to a stock they believed would pick up for too long despite its deteriorating streak only because they don’t want to regret their initial decision of buying it. Such an approach only compounds their losses.
In the same vein, investors often sell off their stock too soon in order to lock in profits, so that they don’t have to risk facing the regret of not doing so.
5. Home Bias
Many investors do not even consider stocks outside their country. This over-reliance on what is familiar limits their chances of maximising their profits by investing in stocks outside their country.
6. Confirmation Bias
We usually tend to be more open to financial advice that suits our inherent biased narratives. Subconsciously, we filter the quality of information coming our way, and adhere only to the ones which confirm our investment assumptions.
Such a confirmation bias prevents us from considering different viewpoints, resulting in less than optimal decisions.
Is it possible to steer clear of these investment behavioural biases? Of course. Let’s take a look at some ways to mitigate our biases.
1. Don’t overestimate the depth of your knowledge
Let’s stop overestimating the quality of information at our disposal and always seek to learn more from the people who have more experience and information. Being open to new and different viewpoints is a must if we seek to enrich our understanding.
You must never forget that you will be up against institutional investors and sophisticated algorithms that have more knowledge and data than you do.
So trade less, and invest more. Extending time-frames, mirroring indexes and utilising dividends will help you grow your wealth over time.
2. Understand the investor in you
It’s very critical to know your biases and prejudices as an investor. Start by asking yourself these questions: What are your investment objectives? How much time are you willing to give to your investments? How risk-friendly are you? Are you the kind that jumps on the bandwagon easily, or do you study the market and the fundamentals carefully? How do you react to market noise and volatility?
Once you’re clear in your head about the answers to these questions, try and identify the biases that are actually impacting your investment growth. You can then try and change them. Having said that, you’ll need a solid drive to do away with your behavioural prejudices and it might not be an easy task.
It’s also advisable to seek help from a financial expert who can guide you on this journey.
3. Ride the market volatility wave
Market volatility has become an unavoidable element in the world of investments, and many of our biases put us in a difficult situation to deal with it. Volatility makes us nervous and we end up acting impatiently — from selling stocks cheaply before a recovery to buying them at a higher price in anticipation of a further hike.
You need mature pragmatic strategies, and not your biases, to ensure market volatility doesn’t dent your investments.
You can consider dollar-cost averaging, a strategy through which you place a small, consistent amount in stocks on a regular basis, despite price fluctuations. Dollar-cost averaging has been shown to be able to generate good returns, as it takes the timing out of investing, and focuses on being in the market over the long term.
It’s also advisable to set reasoned stop loss and take profit points on your stock investment, and then abiding by those. Acting as a shield against unpredictability, stop loss and take profit are predefined points that investors specify and orders are put in place to close a trade when the stock prices either plummet to stop loss point or peak to take profit point.
Specifying stop loss and take profit points not just keep your investments in a safe range despite fluctuations, but also shield your decisions from emotional biases.
4. Keep learning
Nothing more than knowledge helps in overcoming prejudices, and you should leave no stone unturned in your pursuit of financial wisdom. You can always seek the help of a financial expert, or learn on your own.
Consider online studies, books or short courses to learn more about investing and financial planning to make informed decisions, not biased ones.
5. Take the Warren Buffett route
The ‘Oracle of Omaha’ has taught us to buy stocks when others are fearful and sell them when they are confident, basically inspiring us not to blindly follow the herd while making investment decisions.
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