How To Overcome The Negative Effect Of Investor Bias

How To Overcome The Negative Effect Of Investor Bias
Underwater by Andy Deitsch. Why?

We’re all prone to prejudices and preconceptions that cause us to think and act irrationally: understanding the top five investor biases could pay dividends for you and your money.

Professional Traders Know The Best Way To Make Money In The Markets Is To Recognise Your Investor Biases And Act Accordingly

Warning: Investor Bias Can Damage Your Wealth

You make thousands of rational decisions every day. 

Or so you think!

What to eat throughout the day. 

Whether to make a big career move. 

If you should make a particular investment.

Research suggests there are a number of cognitive stumbling blocks that affect your behaviour.  Worryingly, they can prevent you from acting in your own best interests.

By the last count, there are 188 types of these fallible mental shortcuts, as you can see in this fantastic illustration

They constantly impede our ability to make the best decisions about our careers, our relationships, and for building wealth over time.

The illustration below reveals the five cognitive biases that can hurt investors the most.

investor

There is no shortage of cognitive biases out there that can trip up our brains.

Next time you’re considering a major investment decision, it’s worth checking the illustration above.

Here’s a little more information and examples of the five cognitive biases that can impact investors the most.

Anchoring Investor Bias

The first piece of information you see or hear often ends up being an “anchor” for others that follow.

Here’s an example.

You hear a new stock was trading a £3.00. 

That’s the piece of information you may reference whenever you think about that stock in the future.

To avoid this mental mistake, you should analyse the historical data, but don’t hold historical conclusions.

Recency Investor Bias

This is a tendency to overvalue the latest information available.

Here’s an example. 

If you heard the well-respected Chief Executive is resigning from a company of which you own shares, your impulse might be to overvalue this recent news and sell the stock. 

However, you should be careful.  Instead of reacting in haste, it would pay you to focus on the long-term trends and experience to come up with a more measured course of action.

Loss Aversion Investor Bias

No-one wants to lose money.  But losses happen all the time, even for the best investors.  This is especially true on paper.

Here’s an example.

Loss aversion in investor bias is a tendency to feel the effects of these losses more than wins of equal magnitude.

It can often result in a shift in investing strategy.  Investors who are focused only on avoiding losses are likely to miss out on big opportunities for gains.

Bandwagon Investor Bias

No-one wants to miss out.  But being the last one to pile into an opportunity can also be cataclysmic. 

Here’s an example.

There are plenty of examples throughout history of people investing just before a bubble bursts, wiping out much if not all of their money in the process.

If you’re going to be a bandwagon jumper, make sure you’re doing it for the right reasons.

Confirmation Investor Bias

Taking in information only that confirms your beliefs can be disastrous.

Here’s an example.

Often defined as an ‘echo chamber’ in which your ideas and beliefs are amplified and reinforced, it’s easy to be swayed by confirmation bias.  That’s because it’s satisfying to see your previous conviction in a positive light.

But it also makes it possible to miss important findings that may help to change your conviction.

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