Behavioral biases are emotional and psychological factors that impact an individual’s investment decisions. While the markets are sometimes unpredictable, you might end up making irrational decisions. These decisions are based on your preconceived notions. The go-to rule of investing is to keep the emotional outcomes of your investments from driving the decision-making process.
Investment biases are hard to detect because of the cognitive dissonance experienced by the investor. You can simply understand this as making investment decisions based on emotional reasons instead of facts and evidence. The rush for high returns can make you fall prey to investing without analyzing the company’s details, chasing past returns, or even aping someone else’s portfolio.
Let’s take a look at the 5 common behavioral biases and how to avoid them:
Investors and traders with years of experience in the market are confident about their decisions. Since they have tasted success, they tend to believe more in their capabilities. Relying on their past profits, they make impulsive decisions. It leads to overconfidence bias, which may be experienced in the following forms-
You may end up putting risky stakes by following a single trend or betting on a particular stock. It would restrict your thought process while investing. You may either be too conservative or too liberal in your ways when influenced with overconfidence.
Assessing and trusting information
You believe all the information received about any investment scheme. Being too sure of the credibility of your information source may be misleading. It is a bias that may restrict you from conducting proper analysis of a product before investing.
Due to overconfidence bias, investors may develop an ‘illusion of control’. It leads them into believing they can control the situation and manage risk. However, the circumstances may actually not be as unchallenging as it seems.
You can notice changes in your investment style in terms of favoring specific stocks or securities. There is an influence of over-optimism in all your decisions. It might have given you good results in the past. Or you may even overlook external exit cues.
How To Overcome Overconfidence Bias?
Keeping an impartial approach and relying on data is a better investment strategy. You can align your financial goals and investment needs by-
Investors sometimes strongly believe in their investment. They hold their position even when the product may be consistently underperforming. It impacts their entire portfolio. Holding on to non-performing investments for a long duration may result in a larger loss. You can simply understand holding on to bias as the inability to let go of a bad investment.
How To Avoid Holding on to Bias?
Setting up rules for evaluating your investments gives each option a fair chance. These rules will act as guidelines to identify your bias. It will also help you specify a timeline to let go of the investment and avoid further losses.
To protect yourself from holding onto losers, fix a percentage to be the endpoint of holding on to them. It helps you keep track of when to sell if the stock continues to lose its value. These rules must apply to all your investments and keep them unalterable.
Similar to the other biases we have discussed above, bounded rationality is a concept of making rational decisions under the influence of limited or bounded knowledge. It is the perception that you cannot have complete information to make optimal decisions. So, you try to make rational decisions, but only within the circumscribed information you have. In such cases, efficiency gets replaced by comfort derived even from incomplete or passive information.
Bounded rationality leads to investment biases such as recency bias and investment herding. Investors who are investment novices may be using limited or incomplete information when making investment decisions. Recency bias refers to focusing too much on recent events while ignoring previous ones. It leads to impulsive decision-making in absence of deep research.
Investment herding is when you follow the investment trend of the market. It is a common phenomenon among retail and institutional investors across all investment segments. So when investing, you tend to favor schemes that are being talked about by everyone around you.
How To Avoid Bounded Rationality?
Investors commonly suffer from recency bias and anchoring-and-adjustment fallacies when they invest in stocks. Therefore, to address this bias, you need to give up the tendency to neglect new information. You must study the company’s fundamentals and historical performance before investing in it. Another key point to consider is your investment goals. Each individual in your network would have a different financial situation and needs. Their investment style should not influence yours. You must not invest in a product just because they are doing so.
It is advisable to conduct your own research. To simplify the process, you can refer to online investment platforms. They generally provide users with consolidated information about the performance of a company or mutual fund. It will help you make wiser investments that will be profitable for your portfolio.
Confirmation bias can be a result of investment beliefs or investment decisions from the past. Due to losing money in your earlier investments, you may ignore recent and important information. This information could have changed your investment decision, but your resistance to accepting it may result in a larger loss. When suffering from confirmation bias, you will consider only information which supports your preconceived notions about an investment opportunity. You will also favor information that confirms existing investment beliefs and ignore or reject alternate views. It leads to missing out on good investment opportunities.
How To Avoid Confirmation Bias?
The first step in addressing investment confirmation bias is recognizing it. It is quite easy if you look back at your investment decisions and markdown instances of poor decision-making. Then you must analyze what went wrong at that time and how the situation has improved now. These results will help you in overcoming confirmation bias for those products. It will also help you avoid building a confirmation bias in the future and reduce flawed investment decisions.
Most often, investment biases lead to losses. Chasing past performance is another bias that affects your portfolio adversely. It may be a good way to make investment decisions when it comes to buying mutual funds. However, picking other investment instruments, such as stocks individually through active investing strategies, is not advisable.
How To Avoid Chasing Past Returns Bias?
The right investment approach is to be mindful of the fact that the performance of a company and its stocks varies with market fluctuations. You must assess a company based on its underlying strengths and future potential for delivering value to the shareholders. It means staying away from investment decisions driven by instant gratification by paying attention to chasing a return you achieved in the past.
Unbiased investment decision-making may sound like an unachievable ideal condition. But if you keep in mind the traits of each of these behavioral biases, you will be mindful while making an investment decision. Remember the lasting effect these biases will have on your portfolio and immediately adopt a neutral investment mindset to improve your investment returns.
Investing in stocks is unpredictable, but you should stay rational and not let your feelings affect the decision-making process. Behavioral biases influence your investment decisions.
Investing biases will lead to an investment decision based on emotional reasons instead of evidence.
Some common biases are Overconfidence Bias, Holding on to Bias, Bounded Rationality, Confirmation Bias, and Chasing Past Returns.
Under these biases, an investor may be influenced by the past performance of an investment instrument or may prefer investing in a favorite option only. Investors also tend to be overconfident of their skills and take impulsive decisions. Sometimes, they are too hopeful and hold on to non-performing investments longer than needed, incurring large losses.
To overcome these biases you must keep an impartial approach while investing. Rely on data from credible sources and devise an investment strategy as per your needs instead of copying someone else’s investment plan. It is advisable to study factors like company fundamentals, consistency in performance, etc.
Set up rules in your system and specify a timeline to let go of a bad investment and avoid further losses. You must also keep yourself updated about the changes in the market and make decisions based on both historical as well as current data.