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The Tricks Your Mind Plays On You: 20 Biases That Impact Your Investment Success (Part 3/3)
In the final part of this series, we continue going through 20 types of biases that can affect our decision making in life and investments.
The first eight were discussed in Part 1 and Part 2. Please read them if you have not done so already!
In seeking to understand complex matters humans tend to want clear and simple explanations. Unfortunately, some matters are inherently complex or uncertain and do not lend themselves to simple explanations. In fact, some matters are so uncertain that it is not possible to see the future with any clarity. Many investment mistakes are made when people oversimplify uncertain or complex matters.
Albert Einstein said:“Make things as simple as possible, but no more simple.”
Why it is a problem:
We are all prone to taking mental shortcuts when trying to understand complex issues. It’s an adaptation that speeds up the decision-making process. But oversimplification can also lead to a reliance on assumptions and preconceived ideas that might not be accurate.
Recency bias is when the last piece of information is given more value than the information before. If you do a bad investment and then you do a good investment, you are more likely to be overconfident than if you first did a good investment and then a bad one. This is true also in the stock market. In a bull market, we forget about the bear market and are all positive. And in a bear market, we forget about the bull market and are all negative.
We are always more concerned about the recent past than the actual past. And this tendency to think in terms of what happened most recently and taking a decision based on that is recency bias.
How it tricks us:
Think of the recency bias as your short-term memory winning out over your long-term one. Essentially, it's the tendency to believe that what happened in the most recent past will continue to happen in the future.
In investing, recency bias happens when people choose investments for their portfolio based on the most recent top performers, a phenomenon also known as "chasing returns,". So even if you know past results don't predict future performance, it's the most recent run-up that tends to stay in your mind.
How to avoid recency bias:
The best way to avoid this bias is to stick to the fundamentals and stick your investment strategy. That is look at the category, its past performances and then try to analyze whether it is the right fit for your investment rather than judging an asset based on its current returns.
Also remember that generally speaking, what goes up will eventually go down when it comes to the markets. So getting in on the market when it's riding high, and pulling out when it drops, potentially leaves you worse off than if you had stayed the course.
Humans tend to ignore or over- or under-estimate probability in decision making.
This type of investing bias refers to a tendency to ignore probability when making an uncertain decision. Although it seems crazy to ignore basic odds, it occurs often.
This presents itself when an investor either entirely ignores small risks or hugely inflates them.
Since this may be hard to fully understand, consider the following example:
You’re choosing between two investments. In one, you can earn $10 million, and in the other you can earn $10,000. With the first one, you can retire and live out your life exactly how you want. With the second one, you can take a couple lavash vacations, but then it’s back to reality. The odds of success in the first investment are one in 100 million, whereas in the second investment it’s one in 10,000. Choose one.
Most people’s tendency is to choose the first, even though the odds are significantly better in the second option. In this case, the difference in probabilities is ignored simply because both are extremes.
The bandwagon effect, or groupthink bias, operates on the assumption that there is ‘safety in numbers’. Investors take comfort in knowing that ‘everyone is doing it’ and believe that ‘everyone can’t be wrong’.
Measuring one’s results using others as a reference point can lead to the bandwagon effect, or herd behavior, where following the crowd feels safer because it eliminates the risk of loss as compared with the reference group, even if the absolute risk is substantial.
To be a successful investor, you must be able to analyze and think independently. Speculative bubbles are typically the result of groupthink and herd mentality. We should find no comfort in the fact that other people are doing certain things or that people agree with us. At the end of the day, we will be right or wrong because our analysis and judgement is either right or wrong.
People follow the herd because it feels safer. There's also the "fear of missing out": If your colleagues are making money investing some risky new small crypto, it feels uncomfortable to sit on the sidelines.
We have all seen this or experienced it ourselves. “If everyone else is buying it, it needs to be good”. Does it need to be good just because many people buy it? Who are these people? How can you know that they know what they are doing?
Even before going to a restaurant or watching a movie, we often rely on the fact what others are saying about it. We read reviews and look at the rating to form an opinion without experiencing it ourselves.
This ‘power-of-the-crowd’ mentality influences our investment decisions too. For example, we often make our investment decisions based on what the people around us are doing. All of us, at least once in our lifetime, have put money into something just because someone from the family did it or because a friend has told us that it is a good investment opportunity. For example, if all your friends are investing in “shitcoins”, you might start too, even though it is risky.
Herd behavior can backfire. It can create massive bubbles like the Dutch tulip market bubble, the Dot-Com bubble, and the real estate bubble of the mid-2000s. And bubbles burst.
How to outsmart the Bandwagon Effect:
Do your own due diligence. Don’t just follow the crowd.
Your investment portfolio decisions should be based on research, your individual situation, your current asset mix, your investing timeline, and your risk tolerance. If you don't truly understand what you're putting your money into, or if the investment isn't a good fit for your portfolio, brush off that peer pressure.
Step back and look at investments carefully, and be skeptical of hot stocks or cryptos promoted on internet forums or making news headlines. Instead, make a conscious effort to make your own investment decision. Try to find out whether such investments can help you achieve your financial goals in a timely manner. What might have worked for your friend or a family member as per his/her investment objective, might not be the right fit for your goal.
Warren Buffett became one of the most successful investors in the world by resisting the bandwagon effect. His famous advice to be greedy when others are fearful and fearful when others are greedy is a denouncement of this bias. Going back to confirmation bias, investors feel better when they are investing along with the crowd. But as Buffett has proven, an opposite mentality, after exhaustive research, may prove more profitable.
This "contrarian thinking" is also the basis for for approaches such as the crypto fear and greed index. It makes more sense, and likely more money, to buy when the fear is at its extreme, and to sell when the greed is very high, than to do the opposite.
This is the false belief that recent winning streak will continue to the future without regards to other available data.
For example, a particular share has made profits every day for the past 15 days. Based on this profitability streak alone, an excited investor pumped in more money to invest than he could afford, betting it will continue to rise regardless of other economic indicators. The investor only consider one factor for buying the share i.e. the current price upward trending of the share.
Why avoid the hot hand fallacy?
For investing, being foolhardy is dangerous when the market is bullish.
Following up on the example above, imagine when emotions are running high. Prices rising for 15 days in a row and the market talk says it will continue to increase for the next 10 days. Everybody is buying. In your mind, you are thinking if you don’t buy, you will lose out (herd mentality). Thus, you invest more money than you can afford. All the time-tested sound investment principles forgotten in the midst of the excitement. The next day, Bang!… the market collapses (an extreme assumption) or the share price suddenly makes a sharp downturn.
How to avoid or overcome the hot hand fallacy?
It‘s wise to be cautious. Investing with emotion is gambling. Instead of placing an investment decision on recent events, analyze the trends and patterns of the share price movements. Unless you look for short-term gain, long-term investing is the way.
Practice sound investing principles before parting with your money.
A win expected after a succession of losses (or vice versa).
What is the gambler’s fallacy:?
Gambler’s fallacy is an incorrect presumption that say:
If a particular event/effect/result happens again and again in a row, the opposite result is certain to occur soon.
We often interprets the outcomes of a future event by judging its corresponding past events even if the two are completely independent of each other.
Best example to illustrate this fallacy is the coin toss. Assuming the first four toss is all head, what do you think will be the fifth toss? Head or tail? Tail right? Since head four times in a row. That’s the answer given by most people. And this is gambler fallacy at play. Probability theory suggest the answer is 50/50 for either head or tail. Past tosses do not influenced future toss result.
Why you should avoid it:
Emotional investing using your heart would not generate wealth for you. The stock market operate based on the underlying company fundamentals.
In investing, gambler’s fallacy is widespread. Investors believed that a share price continuous daily climb can’t be forever. As such, many start to sell prematurely and lose out.
The day share price is independent to the previous days prices. Investors should base their buy or sell decision on fundamental analysis. (fundamental analysis refers to the examination of the economic health of an entity as opposed to only its price movements).
How to avoid the Gambler’s Fallacy:
Always remember this: your past successes or failures have no influence on the result of your next transaction. Investors should use fundamental analysis to predict what will happen.
Don’t gamble. Stop making investing decisions that depend completely on probability.
Analysis Paralysis. You overanalyzed a situation resulting to inaction i.e. no outcome. Too much information resulting in brain freeze or paralysis.
Why you should avoid it:
Often, you came across a good investment deal. Your gut feeling is telling you to go for it. The main indicators are there. But your analytical background is cautioning you to analyze further. You cave-in (loss aversion bias) and seek further information. The more data you analyze the more you are unsure and get confused about it. The deal passed by and that that. No action, no outcome. And the actual outcome? You lost a chance to a 20% gain after 3 months.
How to avoid it:
Many investors over-analyze with many statistics, indicators, checklist to fill in. There are news to look at, expert‘s opinion and other indicators to digest. They want to be 100% sure they got it right (perfect result) before parting with their money. This leads to analysis paralysis.
Best solution? Stick to a consistent trading strategy.
Briefly, your trading strategy should decide the following:
Whether the share is cheap or expensive or fair value
If a share is cheap/expensive, decide if you wants to buy/sell that asset
Given that a share is fairly priced and if we hold a position in that share (bought or sold it earlier), decide if you want to exit that position or the price (or price range) that you want to make this trade at.
From soaps to clothes to restaurants to investments, today we are all spoilt for choices. Moreover, we are bombarded with information through print, electronic and social media. Now, the excess of choice makes the decision difficult and this dilemma is identified as choice paralysis.
In terms of investments, while making an investment, one might get lost in the asset types, investment schemes, etc. This dilemma often leads to taking no action.
How to avoid choice paralysis:
While making an investment decision, first be very clear on the risk you are willing to take and the returns you expect. Try to narrow down your choices.
For instance, for equity mutual funds, if you are okay with taking slightly higher risk for higher returns, you will automatically have a shortlist of categories you should consider. Similarly, if consistency is more important than one off high returns, you then filter options based on that criteria.
Limiting your choice is the only way to overcome choice paralysis.
Overconfidence bias is the tendency to see ourselves as better than we are. It's common in investing.
“I have an edge that you (and others) do not.”
A person with overconfidence bias believes that their skill as an investor is better than others' skills.
For example, a person who works in the pharmaceutical industry may believe in having the ability to trade within that sector at a higher level than other traders. The market has made fools out of the most respected traders. It can do the same to anyone.
Why it is a problem:
The problem with the overconfidence bias is that it can make an investor overestimate their abilities and knowledge, which can lead to rash or poor decisions. For example, overconfidence in investing skills can lead someone to believe they can accurately time the market (even though markets are notoriously unpredictable).
How to overcome overconfidence bias:
Be honest with yourself about your trading skills and ability.
Be aware that you tend to feel more certain about an investment future than it is. This means you tend to take more risks than you think you are taking. Investors should always add an extra margin of safety in their decisions.
If you're a beginning investor, consult a professional and get a gut check on your investing strategy to solicit alternative perspectives. Consider sticking to passive investing rather than trying to time the markets.
This concludes this 3 part series on investment psychology.
I hope this series was helpful by introducing / reminding you of these 20 types of biases. Please stay alert to these biases when making important life or investment decisions.
Do you have any stories to share that are related to this topic? Please do so in the comments below. Any feedback is also very welcome.