Human beings often consider themselves as rational, but that’s not true.
There are common biases, both cognitive and emotional, that everyone falls prey to. Cognitive biases are the blind spots or inaccuracies in our thinking, while emotional biases arise from impulse and intuition rather than conscious reasoning and can be challenging to correct.
Although it’s impossible to avoid these biases, being aware of them can help mitigate their impact.
“The whole trick in life is to get so that your own brain doesn’t mislead you.”
Charlie Munger, Vice Chairman Berkshire Hathaway
Here are 5 biases to watch out for:
1. Confirmation Bias
People don’t like being wrong about things. In all facets of life, we, whether consciously or not, seek out information that confirms our already-held beliefs and ignore facts or data that contradicts these beliefs.
One of the best examples of this is becoming overly optimistic in a stock, asset class, or commodity. They instantly discount any negative information that doesn’t fit in with their already-held positive outlook.
This can lead to way too much concentration in one investment and disastrous consequences if you aren’t right.
A good way to avoid this is to copy Charles Darwin. Whenever he had a theory about something, he worked tirelessly to find evidence that would prove him wrong. This is the exact opposite of what we’re naturally inclined to do, so it takes a lot of practice.
Another good idea is always to have someone you trust to bounce ideas off of. Someone who isn’t afraid to tell you a different viewpoint.
2. Information Bias
The human mind desires coherence and a sense of control. This leads us to seek answers and form our own stories when there’s an absence of information.
This can cause us to evaluate and give credence to information that is useless.
Look at the huge industry of analysts and prognosticators. Every day, investors are bombarded with useless information about what a stock is doing today or how the markets will supposedly perform in the next year.
Even though the evidence shows that none of this can be reliably predicted, this doesn’t fit with our natural desire for control and certainty. This leads people to make serious investment decisions based on useless information.
Most of what you read online is pointless. It’s filler that won’t help you make better decisions and is meant to consume your attention so the website can sell more advertisements.
When you’re reading something, stop to consider: Is this important? Does this have detailed information? Is the writer unbiased and well-informed on the topic?
3. Herd Mentality
Herd mentality refers to investors’ tendency to follow and copy what others are doing.
People making decisions under the herd mentality bias are largely guided by instinct and a desire to conform rather than by their own independent analysis.
We see this in investing all the time and it is a common cause of asset bubbles. Consider crypto currency over the last couple of years.
Many people who ended up buying crypto currencies had no idea what they were investing in.
They didn’t have a deep appreciation of the asset based on any meaningful analysis. Instead, they were driven by an increasing amount of their peers being drawn into the space. They were bombarded with commercials like this.
They didn’t understand what they were buying but felt comfortable because everyone else seemed to be doing it.
Even professional investors fall victim to herd mentality. “One study, called “Thy Neighbor’s Portfolio” found that mutual fund managers were more likely to buy or sell a particular stock if other managers in the same city were also buying or selling.
4. Recency Bias
Recency bias refers to the tendency of investors to give greater weight to more recent information to the extent that they may overlook or undervalue historical trends and data.
This manifests itself in two main ways. The first is investors picking investments based on meaningless short-term performance.
The second way is adjusting your investment risk tolerance based on what the markets are currently doing. Your investment risk profile should be carefully thought out, balancing your capacity and risk tolerance and the required rate of return to reach your financial goals.
Instead, too often, investors adjust their risk profile based on what the market is doing. During bull markets, they feel like they’re missing out, so they will become more aggressive than they should be.
Conversely, during bear markets, they will get overly conservative.
Try and have a long-term mindset. Avoid short-term noise that is meaningless to your goals.
5. Overconfidence Bias
Overconfidence bias refers to the tendency of investors to have an exaggerated sense of their own abilities.
“Most of us believe we are better performers, more honest and intelligent, have a better future, have a happier marriage, are less vulnerable than the average person, etc. But we can’t all be better than average.” Peter Bevelin
Ample evidence exists showing both that most short-term traders lose money, and the majority of stock pickers are unable to do better than a index fund.
This has not stopped people from trying to do this, believing that they are the exception to the rule.
Overconfidence bias can snowball on itself. One successful investment can lead people to believe they can keep doing it and compel them to take greater risk.
This happened a lot during the post-pandemic stock market. A hot stock market lured in new investors with little previous experience. There was so much easy money being made, and many mistook luck for their own trading abilities.
The Wall Street Journal recently profiled Omar Ghias, an amateur trader who amassed roughly $1.5 million portfolio during the early part of the pandemic. He did this through trading various stocks, and options. He amplified his positions by using leverage, and borrowing from his brokerage firm.
It all seemed so easy. Mr. Ghias dropped out of school so he could trade full time, and he showed off his trading exploits on TikTok.
As the bull market ended, things began to unravel for Mr. Ghias and many others who realized that the stock market doesn’t provide endless short-term riches.
Now, his $1,500,000 is gone, and he’s left with about $15,000 in credit card debt, $36,000 in auto loans and $6.99 in a checking account. He’s working in a deli, and selling timeshares.
“I felt like I was indestructible,” Mr. Ghias said of his trading days. “It was irrational.”
The views and opinions expressed in this article may not necessarily reflect those of IPC Securities Corporation