We all like to think that we’re rational thinkers and make decisions based on logic and facts. The truth is our brains are hardwired to biases that can often lead us astray. When it comes to investing, these biases can have disastrous consequences.
In this blog post, we’ll look at some of the most common biases that can impact investors and why it’s so important to be aware of them. By understanding these biases, you can stand a better chance of avoiding them and making more successful investment decisions.
Bias – The Good and the Bad
At its core, bias is an inclination that affects the way we think or act on a matter.
Everyone holds personal biases in one form or another. We’re biased about our favorite foods, relationships, and political views.
Much of the time, these biases are working to our advantage. They help us sort through and categorize all the information coming at us so that we can function in our lives.
Think about this.
If we had to independently verify whether it was safe to shake the hand of every person one of our friends introduced us to, the preparation necessary for every party we attended would probably keep us at home.Instead, we have a bias to trust our friend’s friends, and we go to the party excited to meet others.
Biases can also work against us.They can color how we perceive things, cause us to feel a certain way, or cause us to misinterpret facts without realizing it.
“Bias-as-bad” can be seen in all sorts of situations – personal relationships, workplace interactions, personal financial investments – and it’s essential to be aware of so we make more conscious, informed decisions.
Unrecognized personal bias can lead us down paths we wouldn’t intentionally choose or prevent us from seeking different opinions that might actually serve us. For instance, a bias towards trusting our friend’s friends could make us prone to falling for a fraud scheme because that bias “turns off” other information that might cause us to do more research or be more discerning.
Common investing biases
Unbeknownst to many, our emotions and beliefs play a significant role in how we invest. To navigate successfully, it’s important to be aware of the four common types of bias: overconfidence bias, confirmation bias, herding bias, and loss aversion bias.
Overconfidence bias occurs when investors overestimate their abilities or knowledge. They may believe they have access to reliable inside information or that they’re skilled enough to outsmart the stock market.
This often has investors buying too much of an asset or putting too much of one’s money into one investment, which, of course, is fine, until it isn’t. This bias causes people to jump outside the guardrails of diversification and avoiding concentrated positions.
Confirmation bias is when investors seek information that supports their already-held beliefs, leading to overtrading and increased costs.
This often has people ignoring the “writing on the wall,” which is seen pretty clearly in retrospect when investments go sour.
Herding bias happens when investors tend to follow a trend or the decisions of others instead of doing their independent research.
This explains the Game Stop phenomenon, the Theranos debacle, as well as much of the cryptocurrency hype of recent years.
Loss aversion bias
Finally, loss aversion bias can cause investors to “play defense,” selling off winning stocks too soon in order to protect against potential losses. Or worse, sitting on the sidelines in cash waiting until it is “safe” to get back in, and missing out on the best days in the market.
While understanding why these biases exist, acknowledging them and making sound decisions despite them can make all the difference in an investor’s success.
Managing bias in choosing investments
Whether you’re investing in stocks, currencies, or funds, it’s important to be aware of pre-existing patterns and tendencies that could affect your decision-making.
First, create an “anchor”
Investing is a long game. Even if you are a day-trader or only intend to hold an asset for a short time period, your goal is to have more money over the long-term. Having a solid plan with a focus on the end game. Make a plan. Have that be your guide at all times.
Then pick investments
As you choose your investments, ask yourself these questions:
- How much risk am I willing to take?
- (or, said another way) How much money am I willing to lose?
- What are my assumptions about the performance investment?
- How did I come to accept these assumptions?
- Was there “writing on the wall” somewhere that I didn’t want to see?
- Where might I find a differing opinion?
- How diversified do I want to be?
- Am I too focused on lowering fees and missing a better value elsewhere?
- How up-to-date is my information?
- When was the last time I took a big-picture look at a particular investment, industry or trend?
- Is this an appropriate amount of money for me to invest in this particular investment?
- When was the last time I heard a new perspective on this investment?
You should review any biases before executing a trade―even if they appear minor―and keep an open mind to take advantage of potential opportunities presented by the ever-changing markets. Taking these steps will help improve decision quality and overall performance when investing in the future.
Remember: Everyone has bias. The trick is to be mindful where bias is helpful and where it is harmful. When it comes to investing, being doubly sure you’re watching your assumptions and information sources is key to success.
If you want to talk about your own bias or find a way to get your bias out of the picture completely, please reach out.
Lanning Financial Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.