Science suggests we are wired to delude ourselves and fall for certain biases that trick our brains.🧠
According to a study for MagnifyMoney, 66% of investors have regretted impulsive or emotional investments.
And for 58% of investors, their portfolio actually performs better when they successfully remove emotions from the equation, but that’s easier said than done…
Investing is rife with faulty thinking habits, which can lead to poor decisions, and potentially eat away at returns.
In this article, we describe the 4 most dangerous behavioral biases and give some practical tips for how to remove them from your investment decision-making.
Let's get started.
What is a bias, in simple words?
A bias is our perception of how things should be, even when it's not true.
In other words, a bias is when we assume something based on our experiences or beliefs. For example, sports fans may claim that their hometown teams are the best ⛹️♂️, no matter how well they actually perform.
For many people, investing (and savings) works in the same way, involving a number of different biases.
We will look at the most common ones and explain how to avoid them to help you make impartial investment decisions.
Investing biases: what are they?
Investing involves a lot of steps, from collecting data to evaluating your investment options and buying and selling those investments.
With today’s information overload, it’s easy to fall into psychological traps and overlook some important aspects that may affect your investment decision.
But worry not! You can easily avoid these pitfalls if you learn how to identify, understand, and overcome them. And we are here to help.🤓
So, the most common investors' biases are (drumroll, please)…
Emotional investment: Anchoring or Confirmation Bias
As they say, first impressions are hard to shake.
Confirmation bias makes us seek out information that matches our existing beliefs and reject information that doesn’t.
This simply means that investors with confirmation bias are more likely to focus only on information that reinforces their opinion about a specific investment.
For example, investors may stick with a declining company stock far longer than they should, just because they interpret every piece of news about the company positively, seeking to reinforce their belief that the company is still a good investment.
As a result, confirmation bias can make our investing behavior irrational. By drawing incorrect conclusions based on faulty reasoning, we may make undesirable investment decisions.
How to solve confirmation bias?
First, be aware of the danger of confirmation bias and recognize that it can cloud your judgment. Second, actively seek out and understand information that’s at odds with your existing beliefs.
As Charlie Munger, the Vice Chairman of Berkshire Hathaway and Warren Buffett’s closest partner, once said: “Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”
Emotional investment: Loss Aversion Bias
Losing actually hurts.
Psychologically, the pain of losing is much more powerful than the pleasure of gaining. In other words, people will often prefer not to lose €50 than to find €50.
So, to avoid losses, an investor could hold on to a losing asset for too long, hoping that they will eventually turn it around.
Such an investment strategy could lead to taking on too much risk, resulting in even larger losses down the road.
How to solve loss aversion bias?
You can avoid loss aversion bias by not getting too emotionally involved in your investments. Many of the risks associated with investments are beyond our control. So if the only thing holding you back from selling an investment is the loss it's made, it might be time to sell.
That’s why sometimes it may be better to accept a loss, especially when investing in riskier investments like stocks and crypto. You can always then move the funds to safer investment options, like gold and precious metals.😉
Emotional investment: Narrative Bias
People love stories. And that’s what narrative bias is all about.
This bias refers to the tendency of people to interpret information as part of a larger narrative, regardless of whether the facts actually support it.
For example, investors may prefer to make investments they can relate to through a memorable or inspiring story.
Take a look at these two examples:
- A small tech company with sluggish sales growth that has decreased by 40% and lost earnings for six consecutive quarters.
- A struggling company that builds next-generation design tools for the web just hired a charismatic CEO, Warren Musk, who was quoted by Bloomberg as promising a quick turnaround for the company and vowing to increase investments and revamp sales.
You may be surprised, but you’ve just read two descriptions of the exact same (made-up) company. See what a difference a good narrative actually makes?
The right narrative can entice investors into buying a stock, often at sky-high prices. That’s why "story stocks" have become so popular.
💡What are story stocks?
Story stocks are stocks that trade based on a story surrounding them rather than on the company's earnings, future growth, etc.
Although not actually a stock, Bitcoin once was a number one story in the market. One of the narratives related to bitcoin and other cryptocurrencies is that they will eventually replace paper currencies as the most common form of money… or that it is “competing” with gold as a store of value.
Read our SPOTLIGHT to learn the key differences and similarities between gold and bitcoin.
Other examples of “story stocks” include some of the most famous companies today, like Tesla and Amazon. In fact, Amazon is considered the most successful “story stock” of all time.
But if a narrative surrounding the stock turns out to be a bubble, we might be in trouble. Sometimes, investors can be lured into a poor decision by a compelling story, which can make them lose money as a result.
How to solve narrative bias?
When researching your investments, you shouldn't completely ignore the story behind them, but look for information that supports or contradicts it.
In other words, analyze objective information that proves or disproves the investment narrative you’re dealing with.
Emotional investment: Overconfidence Bias
“I’m better than you.” — Every mildly successful investor.
Overconfidence bias is the tendency of a person to overestimate their abilities. It may lead us to think we are better-than-average cooks 🧑🍳 or expert investors.
In investing, overconfidence bias often leads people to overestimate their understanding of financial markets or specific types of investment, ignoring expert advice.
This can result in unsuccessful attempts to time the market or make risky investments without knowing your risk tolerance level.
How to solve overconfidence bias?
Overconfidence bias can be avoided by being realistic about the market and your abilities as an investor. You can study news, charts, and other materials available to you while also being honest with yourself about your investing skills.
Sometimes, instead of trying to time the market, following a well-planned DCA strategy can be the best investment option for you.
If you want to start investing, here are a few practical tips: How to Start Investing in 2022?
So, how do you avoid investment bias?
It is human nature to be biased about something, and investing is no exception. So always keep in mind that your investment decisions, as enlightened as they might seem, can be influenced by emotional biases such as:
- Anchoring or confirmation bias: seeking out information that reinforces your opinions about a specific investment.
- Loss aversion bias: preferring to avoid losses over making an equivalent profit.
- Narrative bias: interpreting information as being part of a larger story, even if the facts don’t support the full story.
- Overconfidence bias: having a tendency to overestimate your abilities and knowledge about the market.
Of course, there’s nothing wrong with biases if you know how to avoid them.
The first step is to recognize that biases can impair your judgment.
The second step is to take action: do thorough research, be curious, and challenge your own beliefs.
That’s how you'll know that you’re making a decision based on facts and analysis rather than thinking tainted by bias.
Of course, there are many more investment biases out there, and we will cover some of them in the future 😉, but if you manage to control those four main ones, you’d already be doing better than most (emotional) investors!