Even the most perceptive and experienced investors, can fall prey to mental errors or biases that lead to poor investment decisions. After all, we are all human, and the emotional part of the brain is faster than the rational part.
This ‘fight or flight’ response served us well when our predecessors saw a bear in the woods, it tends to cause investment mistakes today. While you cannot eliminate mental errors, understanding and identifying common biases can help you make smarter decisions.
Cognitive investing biases involve information processing or memory errors or shortcuts, whereas emotional investing biases involve taking actions based on feelings rather than on facts. See below for the 5 most common investment biases.
1) Confirmation Bias
It is natural for investors to be drawn to information that supports their existing views and opinions. Confirmation bias leads investors to attach more emphasis to information that confirms their belief or supports the outcome they desire. You may also tend to ignore contradictory information.
For instance, if you feel optimistic about the stock market you focus on positive news and ignore the negative.
How to Help Minimize the Effects: Utilize information gathered from a variety of reputable sources. Perform a scenario analysis on the investment. For example, how will the investment perform in a slow growth environment, a recession, or high inflation environment.
2) Overconfidence Bias
A common behavioral bias in investing is overconfidence, which causes investors to overestimate their judgment or the quality of their information or ability. I’ll often asks groups of people: “Raise your hand if you are an above average driver.” Nearly the entire room raises their hand. Are they all above average? Not likely. Many – about half — are some overconfident.
How to Help Minimize the Effects: Develop and stick to a solid investment process. Stick to the process and adjust when the process dictates and not from emotion.
3) Recency Bias
Investors who suffer from recency bias tend to overvalue the most recent information over historical trends. For example, the stock market goes up a lot and investors pile in even more … after the market became more expensive. Or, thinking stocks can only go down more in late 2008 after they already went down much more than what is historically normal.
How to Help Minimize the Effects: Stick to the process. Consider how expensive or cheap an investment may be relative to itself historically and to other investments. Focus on the medium to long-term performance expectations of the investments. You cannot predict the short term.
4) Loss Aversion Bias
Research has shown that humans feel the pain of a loss approximately twice as much as they feel the pleasure of a similarly sized gain. This can lead investors to focus on their investment declines more than gains and can lead to inaction that stagnates the growth of their portfolios.
How To Help Minimize the Effects: Market declines are an inevitable part of investing. Having a financial plan that stress tests market declines and clearly shows how they will or will not impact lifestyle will help.
5) Anchoring Bias
Anchoring bias is the tendency to “anchor” on some irrelevant information. In investing this often manifests in owning individual stocks. For example, you decided to by Goodyear stock at $35 and the price declines to $23. You are anchored on the $35, which is baseless – expect potentially for tax purposes – given where the market is today, and you want to hold on to ‘at least break even.’
How To Help Minimize the Effects: Assess investments based on current market value and future expectations. Choose mutual funds over individual stocks where anchoring is more prone.
Even smart people can make what may appear to be dumb investment decisions. The human brain takes short cuts, which can cause investing mistakes. Even the most rational of humans still use logic to justify and explain their faster-moving feelings. Have a sound process and stick to it. Having a good advisor can help with this and also provide objectivity to your naturally occurring mental errors.