In life, emotion and biases drive most of our decisions, but in investing, it can be very harmful. To be a successful investor in the long term, you must overcome cognitive or psychological biases that often lead to poor decision-making.
Cognitive biases are systematic errors in thinking, processing, and interpreting the information around you and are more subconscious in nature. In other words, your brain is hard-wired to specific conditions and tends to act in a particular manner unconsciously, which can affect your rational decision-making ability.
Generally, emotions, individual motivations, limits in processing information, and social pressure lead to cognitive biases. And, in investments, where thousands of minds are working in tandem to get the most out of their money invested, such investing biases can lead to investment losses or not achieving the investment objectives.
In this blog, we will discuss the five investing biases that you should avoid while investing.
It’s the most common investment bias you see among investors. Also called the ownership effect, people value an object more than they would appreciate it if they didn’t own it. Such biased behavior happens when investors fall in love with the stocks they own or have a loss aversion, where they refuse to sell their loss-making investment.
In investing, investors tend to part ways with winning stocks but hold on to poorly performing stocks in the portfolio. As a result, it adversely impacts the portfolio diversification strategy and investment returns in the long term.
How to avoid it: The best way to overcome endowment bias is to acknowledge it exists and consider the opportunity cost of the investment. In other words, if the returns from the next best investment opportunity are higher, you should consider selling the asset.
You can see the bandwagon effect in other areas of life, not just in investing. It is a psychological phenomenon where individuals adopt certain kinds of behavior, style, or decisions simply because other people are doing so.
For example, buying into an investment theme or stock because other people in the market are doing so, even if it doesn’t fit into the investment strategy. In other words, they are displaying herd behavior. The two factors that drive the bandwagon effect are- the desire to be correct and the fear of missing out (FOMO).
How to avoid it: Stay neutral, be more open-minded and verify information on the internet before coming to any conclusion.
It’s a psychological behavior, where one tends to emphasize pre-existing information they learn when making a decision, for example, following the rosy analyst presentation on stock instead of finding something concerning in the annual report or the company’s financial performance.
Had you found the shortcomings before, you would not believe the rosy analyst presentation. But, here, the first piece of information you learn, called the anchor, influences your decisions.
Another example of anchoring bias in stock investing is referring to the stock price while making your investment decision. If the stock price is closer to or above the five figures (Rs 10,000), you would most likely consider the stock high, irrespective of its book value and lower PE value.
How to avoid: The key to preventing anchoring bias is to increase research on the subject, improve reasoning skills, and take help from experts before making an investment decision.
Sunk-cost Fallacy Bias
In economics, a sunk cost is the cost that has been incurred and cannot be recovered. Similarly, in investing, sunk-cost fallacy bias happens when you tend to continue investing in a loss-making stock because of a previous investment and eventually find it becomes difficult to abandon the asset.
Sunk-cost fallacy bias occurs primarily due to commitment bias. In other words, you continue to support the past decision despite changing scenarios suggesting it isn’t the right decision. Or you are not feeling guilty for not sticking to your past choices.
How to avoid: The key to preventing sunk-cost fallacy bias is looking at the investment’s current and future cost benefits instead of past decisions. And, also staying committed to the investment plan helps.
Humans always look for simplified explanations of complex and uncertain topics. However, the inclination to oversimplify complex and uncertain things leads to a loss of critical information or difficulty in visualizing the big picture with any clarity.
Oversimplification of complex and uncertain matters while investing is the prime cause of many investment mistakes. For example, comparing FMCG and an NBFC company is challenging as both have different business models and follow other metrics. It will be a disaster if we compare the financial metrics of both business models on the same scale, like the profitability ratio.
How to avoid: Staying within the circle of competence is the key and choosing not to invest in stocks or businesses you don’t understand, no matter how simplified the investment case may look.
Many investing biases can come in the way of making good investment decisions. But, you can avoid most of them through the right approach and practice.
The key to overcoming investing biases is to acknowledge that cognitive biases exist. It would help if you dedicated more time researching to test your investment decisions, be open to more viewpoints, and use different investment tools to develop the correct thinking approach and make informed decisions.