Published by Autumn on 29 March, 2021
Without even knowing, many of us have biases that affect our investment decisions, and ultimately outcomes.
Here are 5 Psychological Biases that can hurt your investment returns.
1. Confirmation Bias
Often times, you may already have a pre-existing opinion about a certain investment product based on recent news or recommendations from your family and friends. You may not even realise that subconsciously you tend to tune in to information which confirms your biases. This is known as the confirmation bias, as it creates a false sense of security and blind spots, causing you to become overconfident or bullish about the market, which can be risky in making investment decisions.
To prevent the risk of such confirmation bias, we need to be purposeful in challenging our own assumptions, and compare the various alternatives. Rather than trying to find proof to validate why we would be right, we should be open to the alternatives and other options. This would give us a more holistic view towards the investment.
2. Herd Mentality
In short, FOMO – The Fear Of Missing Out. You don’t want to miss the next Apple or Amazon, so you tend to see what others are doing and get into panic buying or selling whenever there are extreme movements in the market, also known as the stock market bubbles and crashes.
This is known as the herd mentality or bandwagon effect, where people tend to make irrational decisions based on emotions and following the crowd rather than using objective, fact-based reasoning. This often results in overvaluation or undervaluation of the stock. In fact, sometimes such act may even be a form of market manipulation by the bigger players, which is what happened to GameStop share price recently.
Source: Google Finance
As you can see, after a bullish sharp gain overnight, it dropped soon after.
You are advised to do your own due diligence rather than to blindly follow the speculation of the majority. It is recommended to understand the valuation of a stock, through a proper fundamental analysis whenever investing in any stocks.
3. Sunk Cost Fallacy
Another common psychological bias is the sunk cost fallacy. Perhaps you have spent a lump sum investing in a particular stock that turns out to be performing below your purchase price.. Despite knowing that you have made a bad investment, you still stick with it even when there are better options available.
Many investors are stuck in the sunk cost mentality, where they held on to the initial investment, and insist on believing that the stock will make a turn around even though all evidence of the stock market does not seem in favour of that. Instead you choose to believe in the stock and end up buying more to average down your investment.
Again, this ties back to the fundamental analysis and understanding how to read the financial statement of the stock to determine its intrinsic value. A good investor will know when to place their stop limits and when to cut loses.
4. Anchoring Bias
Anchoring Bias is a behavioural bias where the first piece of information that you learn is often used as a reference point of information comparison and to guide your subsequent decisions. Often times, over-reliance on such past information may tamper with your rational decision making process, and defy logical reasoning.
Most investors show anchoring bias when their purchase decision was tied to:
- the recent performance of markets and expect future returns in the same range
- past events and think that the next event in the market will also unfold similarly
- past experiences of losses made and make ‘permanent opinions’ about markets or investments in general.
To overcome anchoring bias, you should always look at historical performance, so that you do not stick to only one reference point. Research can be a good way to defray over-reliance on initial information and encourages you to tap on logical judgement instead.
5. Recency Effect
Recency effect kicks in when you put greater weight to the latest information you’ve received or heard.
Some say that recency bias can make you a lazy investor. With recency effect, you tend to base your judgement that a rising market will continue to appreciate and a declining market will continue to fall. However, that is not the case as seen from the historic performance of most stocks. There will always be an upcycle and a down-cycle due to market correction when a stock is overvalued or undervalued. Ths stock valustion is dependent on the economic outlook and many other external factors.
To mitigate the recency effect, one should invest based on his valuation of the intrinsic value of the stock. You should also take a long term view of the investment rather than short term trading that are merely based on recent performance. History has shown that a high valued stock with good fundamentals will be able to weather the fluctuations and beat the market valuation in the long term.
As you can see, all the five psychological biases are often emotionally charged choices rather than rational and logical decision making. Many investors tend to invest based on their personality traits, emotional state, and psychological make-up. Due to this bias, they think and act in a certain way and consequentially their investment decisions defy logical reasoning.
Does any of these sound familiar to you?
Knowing this emotional psychological bias can be the first step to understanding your investment patterns and be discipline in your investing habits, such that any unexpected turns in market events would not deter you from changing your position unnecessarily. That way, you would be able to beat the market volatility in the long term.
*The information in this article is not intended to be and does not constitute financial advice, investment advice, trading advice, or recommendation of any sort offered or endorsed by Autumn.